Welcome part two of the NUA mini-series. If this is the first one you are reading, it may be worth going back for a quick review of part one in the mini-series just to get some background. Although you are more than welcome to jump in here.
I promised in the last part to spend some time talking about when it makes sense to use Net Unrealized Appreciation. As a reminder, NUA is an advanced financial planning tool. It is designed for people who have company stock in a tax-deferred employer retirement plan. But, just because you fall into this category may not mean you should use NUA.
WHEN NOT TO USE NET UNREALIZED APPRECIATION
Let’s talk quickly about when it may not make sense to use NUA. The simplest example is if your company stock is what a client of mine refers to as “pooper” stock. I’ve been in this industry that is financial services for a long time and never heard that term before he mentioned it. He threw me with this “highly technical” term recently. Basically, it means the company stock has not appreciated.
The advantage with NUA is it allows you to divide up the tax treatment of company stock. The basis, or what was paid for the company stock, gets taxed at ordinary income rates. However, and this is key, the appreciated portion gets taxed at long term capital gains rates.
If you have stock that has not appreciated, you know, pooper stock, NUA most likely does not make sense. There are various reasons, including not enough appreciation to take advantage of lower capital gains rates on the current appreciation. Additionally, if the history of the stock is it has not grown, what are the odds it will start growing after you do NUA and hold onto the stock, which is when you can continue to take advantage of the NUA move.
FOR TIMES TO USE NET UNREALIZED APPRECIATION
Now that we’ve gotten out when not to use NUA, how about we talk quickly when it may make sense. I bet you’ve already figured out the first main point. Yes, if your stock is highly appreciated it could easily make sense to go the Net Unrealized Appreciation route. You know, your stock is the opposite of pooper stock.
The simplest example I like to use is if your stock is now worth $1,000,000 and has a basis of $200,000. Here you see absolute growth of $800,000. This is definitely highly appreciated stock since it has grown tremendously over your time with the company.
In the last episode I gave a break down of the taxes of going the NUA route vs. a traditional route of lump sum distribution or even just as an IRA Rollover. I won’t repeat myself with the specifics, however, there are two things I want to point out.
First, without going the NUA route your company stock is subject to Ordinary Income tax rates. These currently top out at 37%. Also, do you think these rates will go down in the future? The current tax rates for individuals will begin to revert to the older and higher rates in a few years. The top rate for Long-Term Capital Gains is 20%. That is almost half of the current Ordinary Income top rate.
As I mentioned earlier, the basis for the company stock is subject to Ordinary Income, which could be 37%. However, that absolute appreciation of $800,000 in my example is subject to a maximum tax of 20% of Long-Term Capital Gains. This is not a tax conclusion, but 37% of $800,000 is $296,000 and 20% of $800,000 is $160,000. I don’t know anyone who would turn their nose up at keeping an extra $136,000 in their accounts.
GAP BETWEEN TAX RATES
Another way to guesstimate whether it makes sense to do the NUA is simply the bigger the gap between Ordinary Income and Capital Gains rates the better. Again, this comes down to the fact the appreciation on the stock is taxed at the typically lower Long-Term Capital Gains rate. The example I’ve used has been the top ends of both rates – 37% and 20%.
What happens if you aren’t in the highest tax rate? Then it takes a bit more work to do the calculation. The current Ordinary Income rates start at 10% and include levels of 12%, 22%, 24%, 32% and 35% before topping out at 37%. Long-Term Capital Gains rates are a little simpler with 15% and 20%. Both Ordinary Income and Long-Term Capital Gains rates also include a 0% rate for low income situations.
Ultimately, the bigger the gap between Ordinary Income and Long-Term Capital Gains with highly appreciated stock the more benefit you see by going the NUA route.
I mentioned absolute growth in my first reason to take NUA when the stock has grown from a basis of $200,000 to $1,000,000. In this case, the absolute growth was $800,000. Another way to calculate whether NUA makes sense is by determining the percentage growth.
Another quick and dirty example. Let’s say you have company stock now worth $100,000. That is great, but obviously just a fraction of the $1,000,000 value in the absolute example. However, what if your basis was $10,000? Now things get interesting when it comes to NUA. You have stock has increased 10 times. It may be worth talking to a CFP who specializes in NUA to see if now it makes sense.
TIME TO RETIERMENT OR DISTRIBUTION
The final way to measure whether it makes sense to do the good old Net Unrealized Appreciation is the timeframe until you have a qualifying event. In this case, when you qualify to do a distribution. The distribution can be either if you have retired from your job or you will be leaving employment them. The timeframe may not be what you think though.
First time I heard this I thought I heard it backwards. The guideline here is the sooner the distribution the better there may be reason to go NUA. I guess all the years of being taught to let assets grow had me thinking this would be the more time you have until a qualifying distributable event the better. But no, the opposite is the case.
The more time you have at your job the longer you should leave the appreciated stock in a tax-deferred status. This makes complete sense since paying no taxes now is certainly better than paying Ordinary Income, Capital Gains, or both.
This seems like a good place to stop in this first part of the NUA mini-series. Next time we will talk a bit more about taxes, which is everyone’s favorite topic.
SENIOR CLASS TRIPS
In today’s flashback section I’m going back to a senior class trip in high school. Hopefully your school had a senior class trip. My class was one of the final classes to enjoy a spring class trip to a specific destination. I was reminded of it as my younger son is about to finish up high school and there is no school sponsored trip for him. And I don’t think it is a Covid-related thing. I just think high schools have done away with them. That’s probably a good thing as I don’t know if I could convince my wife to let him do a trip like I did. Heck, I’m not sure I could convince myself based on my senior class trip.
I graduated from St. Vincent – St. Mary high school in Akron. You are probably familiar with our most famous alum, LeBron James. Regardless, for years and years the school allowed a senior class trip. Allowed may be a weak word. They sponsored it as the school organized it, teachers were chaperones, and the pick-up and drop-off for the trip was at the high school. The trip was to New Orleans.
Yes, you read that correctly. The school allowed a bunch of “know-it-all” teenagers to go to New Orleans. There were well over one hundred 17- and 18-year old students taken by bus to a town with a rather casual attitude toward underage drinking. I believe 18 was the legal drinking age for New Orleans when they started doing the spring break trip many years before it was my turn. By the time my class went the drinking age jumped, but I don’t recall if it was 19 or 21. It really didn’t matter as we were all loaded up like McLovin. Allegedly.
We all stayed in a hotel outside the French Quarter. I feel bad for anyone else staying at the hotel during the same week. Mornings and early afternoons were usually spent around the pool. Nothing like going on vacation and being surrounded by a bunch of obnoxious teenagers on a school-sponsored trip, right.
Late afternoons and evenings were spent venturing into the French Quarter. There was a strict curfew for us though. I believe it was midnight. All I know is we were told to head home from wherever we were by 11PM to make sure we made it into our room by midnight.
Now, I won’t share any stories. Those go to my grave. Actually, one quick story to share. A few years ago, when I was still on Facebook, an old classmate of mine posted an itinerary of our New Orleans trip. I took a glance at it and did not recognize a single thing. My comment was “We had an itinerary?” There were several other people who seconded my question as no one recalled having set things we were supposed to do.
As I mentioned, they stopped doing the trip right after we went. I think they realized taking underage students to a place known for drinking may not be kosher anymore. Regardless, it was a great trip. Heck, it was so great two of my good friends and I headed back down there a few years later. Once we were all legal.
As always, thanks for taking the time to read this. Please do not hesitate to reach out if I can be of help with your equity compensation-related questions. The easiest thing to do is to click the little green box that reads “Schedule a Meeting” that can be found at the bottom of every page on my website. Or, just click my Calendly link right here.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.