NET UNREALIZED APPRECIATION
In this post I’m following up on a planning topic I mentioned a few posts back. This is Net Unrealized Appreciation. Better known as NUA in my world. This is a great resource for equity compensation and ESOP participants who have concentrated and highly appreciated stock positions. As always, I do my best to stay rather high level in these intro posts as I call them. But don’t worry as I will be starting a mini-series on this topic very soon! With that, let’s get to it.
The short version, as always, is where we will begin. NUA is a powerful, but little known IRS tax break, that is advantageous to equity compensation and ESOP owners who have company stock in a tax-deferred type setting. NUA allows you to pay lower capital gains rates instead of higher ordinary income rates. Yes, again the concept is to not tip Uncle Sam. I mean unless you really want to.
Also, please don’t forget my mantra – “It’s not what you make; it’s what you keep!”
Again, keeping a simple example. You own a bunch of company stock in your workplace tax-deferred retirement plan. Your cost basis for all the stock is $100,000. However, you are now retiring and ready to take a distribution out of your ESOP. The current fair market value of your stock has ballooned to $650,000.
You have a couple of options here. First is you could do what probably 99% of financial advisors would recommend you do. Just roll that entire $650,000 balance into an IRA they can charge a nice fee on. Sadly, most advisors who charge based on assets are interested more in gathering more assets as they then get paid more. Sometimes the best planning techniques that would save the client a boatload of taxes and fees takes a backseat, but I have seriously digressed here. Back on topic. Your first choice is to roll the stock into an IRA. Then when you take the money out it will come out as Ordinary Income. It will be taxed just like you earned it because it has never been taxed.
The next option, and this is the one most advisors do not know about, is the NUA. Heck, most CPAs don’t know about it either. And CPAs, don’t get mad at me because this is what CPAs who specialize in equity compensation and ESOPs tell me. So, take it up with them! With the NUA, you roll the company stock into a taxable account via a lump sum move.
Most assets going from a tax-deferred account, like a 401k, are taxed as ordinary income on the current fair market value. Here is the difference. With company stock that you’ve moved into a taxable account, you are only paying ordinary income on the cost basis. In the case of my simple example, you are treating the $100,000 as ordinary income since this is what you paid for it. When you do sell the shares they are taxed at capital gains rates. Both for the NUA amount and also future growth after you make the distribution. Right now the maximum long-term capital gains rate is 20% and the highest income tax bracket rate is 37%. I think you can figure out which amount is a better to be taxed at.
OTHER FACTORS TO CONSIDER
Although the example I used is a simple and straightforward one, you knew I was going to say it isn’t this easy. Of course not. There are other factors you need to take into consideration with any NUA decision.
One factor is tax rates, specifically the difference between capital gains and ordinary income. Obviously the bigger the gap the bigger the benefit via the NUA. Your income level and/or the amount of appreciation in your company stock play into this consideration.
Next is how much stock appreciation is eligible for NUA. Again, just like the gap on tax rates, the bigger the amount of stock growth eligible for NUA the more benefit you will get out of it. If you have a bunch of stock but it hasn’t increased much from the original cost basis you simply won’t see as much benefit as you would with highly appreciated stock.
The final big factor to consider is how long before you start the distribution of selling the stock and taking the money out. In this case the shorter the amount of time the more advantageous the NUA.
MAIN STEPS OF NUA
I do want to spend a few words breaking down the three main stages or steps of taxes with NUA.
- The first is your Cost Basis is taxed at Ordinary Income. This happens immediately when you do an NUA.
- Next is the actual NUA gain itself. This appreciation is taxed at Capital Gains rates when company shares are sold.
- The final applies to post-distribution gains. Here it may be short or long-term capital gains rates based on how long you held them after the date of distribution.
I’m not to go through any specific examples illustrating good or bad situations when you should do or not do an NUA. The reason is because it will get way too complex now. But come back in future weeks as I break down NUA in greater detail in the mini-series event of the century😊 However, if your current tax rate is lower or the same you expect it to be down the road it may make sense to do an NUA.
IRS RULES TO FOLLOW
Finally, there are four important requirements to take advantage with every NUA. And these are IRS rules they take seriously and enforce.
First, the entire vested balance must be distributed within one tax year.
Next, you also have to distribute all assets from all qualified plans you hold with your employer, even if only one holds company stock.
Third, you cannot convert the shares to cash before distribution. You have to take the distribution of company stock as shares.
Finally, you must have a qualifying event causing you to leave. These include achieving one of the following:
- Separation from the company whose plan holds the stock.
- You’ve reached the age of 59 ½
- You are now disabled.
I think that is enough for now. As always, talk to your tax professional and your CFP® to make sure an NUA is right for you. And honestly, if they aren’t even familiar with the term, spend a little time finding a specialist in this highly technical area. It is too good of a benefit to avoid simply because someone doesn’t want to take the time to understand it. Plus, this is an advanced financial planning resource so not every financial advisor is proficient with it.
Finally, this was a very general and high-level overview of Net Unrealized Appreciation. I will be going into more detail in future posts. My point is don’t rely on the general descriptions I’ve shared here as anything more than a starting point. We’ll get deeper in future posts, but just like I said in the previous paragraph, talk to your CPA and/or CFP® about whether NUA makes sense for you.
FLASHBACK - ROCKY THE MOVIE
In today’s flashback, I thought I would share some useless information about Rocky. We all remember that movie from our youth. I heard an interesting interview Howard Stern did with Sly Stallone. Short version is Stallone wrote the script and no one wanted him to have any part with it. Simply he wanted to star in the movie. Even his agents were saying to sell the script and take the money. He was offered $360,000 back in the mid-70s for it.
Stallone took a risk on himself. He was used to be super poor and knew he couldn’t live with himself if he sold it and it became a success for someone else acting in it. Fortunately, he was able to get some producers to mortgage their homes and back his attempt at starring in the movie he wrote. The studio continued to have a bunch of restrictions on the film, including a super short period to film it. They shot the whole film in 28 days. The rest they say is history.
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.