NUA Mini Series - Part 3 - Taxes!
Welcome part three of the NUA mini-series. Yes, there are two previous segments you may want to read. Although you are more than welcome to jump in here.
So far we’ve covered distributions options for NUA and also dug deeper into when it makes sense to do NUA. As part of that, we also covered when it may make sense not to do NUA. As a reminder, NUA stands for Net Unrealized Appreciation. This is an advanced financial planning technique for people who own company stock within tax-deferred workplace retirement plans. The key here is the stock has appreciated since they acquired it. NUA is a way to potentially save significant amounts in taxes.
Speaking of taxes, how about we dive into this important topic. If you know me, you know I have a few mantras when it comes to taxes. First, it isn’t what you make; it’s what you keep. After-tax is what I care about. The other is there is no reason to tip Uncle Sam. I’m not talking about doing anything illegal or even questionable. I’m simply saying you need to take advantage of the tax-savings opportunities the IRS allows.
How about we start with the basics of taxes for Net Unrealized Appreciation. If you’ve read other posts or listened to my podcast, you will recall the whole concept of NUA is to reduce your taxes so you keep more of the stock’s gains in your pockets. Again, not what you make, but what you keep.
As a basic example, let’s say you acquired company stock in a tax-deferred retirement plan over the years that has a cost basis of $200,000. Fortunately, the company has done well and the stock has grown tremendously. Your stock is now worth $1,000,000.
You retire from the company and are trying to decide what to do with this highly appreciated stock. One option you have is to take a lump sum, which would cause that entire $1,000,000 to be taxed at ordinary income levels. You know, it would look like you made $1,000,000 in the year you took a lump sum. Another option is you could roll that money to an Individual Retirement Account (IRA). This is what most advisors recommend. Here you avoid taxes for now, but as you take money out the distributions are taxed at ordinary income levels. So, when Required Minimum Distributions, better known as RMDs, kick in you are dealing with mandatory taxes.
I mention these two options because they come into play with the basic tax structure of NUA. Now, most advisors just go the Rollover IRA route because it is simple to do and it often makes sense. However, in a case like the one I mentioned above it may not be your best option. The NUA is a Lump Sum technique, but you get to take advantage of some IRS rules designed specifically for situations such as this. Instead of the whole $1,000,000 being taxed as ordinary income, only the cost basis is. The rest is taxed as long-term capital gains.
Let’s dig a little deeper into our example. When you go the NUA route, the $200,000 of basis is taxed at ordinary income levels. Right now, the highest ordinary income tax level is 37%. The stock’s growth of $800,000 is taxed at long-term capital gains rates. The highest rate here is 20%.
So, if you did the standard lump sum distribution of the $1,000,000 you could be looking at a tax bill of $370,000 based on ordinary income. By going the NUA route, you are looking at $200,000 being taxed at ordinary income and then the $800,000 of growth being taxed at long-term capital gains rates. This could result in maximum taxes of $74,000 of ordinary income and $160,000 of long-term capital gains. I don’t know about you, but paying $234,000 of taxes seems more palatable than paying $370,000 of taxes.
So, there is the basic when it comes to the huge tax advantage NUA can give someone. There are several more details I want to cover. This is where you can tell if an advisor truly knows what an NUA is versus the person who remembers the term from their training when they first started as an advisor.
I’m going to start with a couple of the easiest tax rules with NUA. First, NUA is NOT subject to the Medicare Net Investment Surcharge Tax. Going the NUA route may save you another 3.8% of taxes on that growth. Not a bad deal. I mean, unless you want to pay almost another 4% in taxes.
The next rule is key if you do NUA. You MUST report it to your CPA or whoever does your taxes. When I say report, I simply mean you have to tell them you did NUA. If you just think your CPA is going to know you did the NUA by reviewing the tax forms you gave him, you are wrong. It is not the CPA’s fault in this case so no trying to blame him or her. NUA is not always reported on anything like the 1099-R. Again, you must verbally tell your CPA you did a Net Unrealized Appreciation with that tax-deferred company stock.
Your next tax-related tip is that for any growth in the company stock after you do the NUA follows the traditional capital gains rules. Those are simply that if you hold the stock for a year or less the gains are treated at short-term capital gains. Holding the stock for more than a year gets you long-term capital gains. A quick example here is if you sell some company stock 4 months after the NUA and it has appreciated 20%, you are paying short-term capital gains.
The last tax tip I want to mention is one I won’t go deep into because it will get incredibly complex quickly. However, I do want to mention what happens if you inherit company stock that could be eligible for NUA. The most important thing for you to know is there is no step-up in basis in these situations. That’s all the deeper I want to go because it is complex and rare. If you are dealing with this situation, just reach out to me directly.
PUBLIC vs PRIVATE STOCK
The final thing I want to mention about NUA and taxes is the difference between public and private stock. Both types of stock are eligible to do the NUA. However, with private stock you have to sell it back to the company after you complete the NUA. There is no opportunity for continued growth down the road with private company stock as you will no longer own it once you leave employment there. This is true regardless of doing the NUA or not.
Please do NOT let this dissuade you from at least looking at the NUA route. It may still make sense just on the growth portion of the company stock. I have the expressions of cutting off your nose and throwing out the baby with the bathwater running through my head as I mention this part. Again, you may not get to enjoy all the benefits of NUA as a publicly traded stock, however, there are still a ton of tax advantages to enjoy with NUA for private stock.
The next post will be the part four of this NUA mini-series. There we will talk about the events that must occur to qualify for NUA and some other important rules.
FLASHBACK – SCHOOL CROSSING GUARDS
Alright, now that spring is fully here and actually by the time this episode drops school may even be out, I figured I would touch on a summer-related topic from back when I was in grade school. This may be something that is just unique to my hometown, but I doubt it.
I grew up in Cuyahoga Falls and went to a local grade school. We had lots of kids walking to and home from school every day. To help kids get safely across the street we had student crossing guards. These were the super old 7th and 8th graders. Who is more responsible than a bunch of 12 and 13-year olds?
In case you aren’t familiar with crossing guards, we wore these bright orange vests. Well, they really weren’t vests but I don’t know what else to call them. There was about a 3-inch wide part that went around your waist and another 3-inch wide section that went down from one shoulder to the opposite hip where it connected to the part around your waist. I guess it was kind of like what beauty pageant winners wear, except with a belt-like addition. But, we had a giant badge that went with ours too.
Regardless of our fashion, our job was to hold up a Stop sign when people wanted to cross the sidewalks. Grade school crossing guards were popular at my grade school because we were rewarded at the end of the year. Yeah, you had to stay a few minutes after school and stand outside in bad weather, but in the Falls we received a summer pass to the municipal swimming pools.
This was key for those of us in 8th grade who would be in high school in a few short months. My group of friends and I all had bikes and were allowed to ride from our homes to the two town pools, one of which was on the other side of town. This gave us a greater sense of freedom and we had a chance to meet other kids our age.
Overall, spending a bit of time after school helping younger kids get safely across the street was worth it for the pool passes. I can’t recall the last time I saw a kid being a crossing guard, but it was a fun job I had when I was a kid. Oh, and I do recall that other towns had them. I remember someone I know telling me she was one years ago in her hometown. I guess she took it so seriously she threw her Stop sign at a car that failed to stop once. Some of us took that job dang seriously.
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.