Planning Considerations for Net Unrealized Appreciation

General Mechanics

NUA is available when there is a lump-sum distribution from a qualified plan. Said differently, the qualified plan [e.g., 401(k)] must be completely distributed over the course of the recipient’s tax year. Aggregation rules apply here as well, including the employee’s entire balance from all of the employer’s qualified plans (i.e., multiple plans with same employer). In addition to completely distributing out the assets from the plan during the course of one year, it must also occur after one of the following triggering events under IRC § 402(e)(4)(D)(i). These are distributions payable to the recipient:

• on account of the employee’s death,
• after the employee attains age 59 ½,
• on account of the employee’s separation from service, or
• after the employee has become disabled [within the meaning of IRC § 72(m)(7)].

Any NUA attributable to employer securities is excluded from gross income in the case of a lump-sum distribution under IRC 402(e)(4)(B). The taxpayer does include in gross income, however, the cost basis in the shares at the time of distribution.

Example: John is currently 57 years old and his 401(k) plan account has purchased employer stock over the years at a cost of $250,000. It is valued at $1,000,000. In addition to the $1 million of employer stock, he has $2 million of other investments in his 401(k). John takes a lump-sum distribution from the plan and moves the $1 million of employer stock to a taxable brokerage account and rolls over the other $2 million to an IRA. Unless John opts out, the $750,000 of NUA is excluded from gross income, but he will pay income tax on the $250,000 of basis.

John may also be subject to an additional 10% tax on the $250,000 cost basis included in gross income under IRC 72(t)(1) because he is under age 59 ½. The “Rule of 55” under 72(t)(2)(v), however, may provide an exception if John separated from service in the year he reached the age of 55 (or older). For clarity, the Rule of 55 exception relies on the age of separation from service, not simply when a distribution occurs.

It is very common for a taxpayer to consult with their CPA when consolidating multiple retirement plans from previous employers into one IRA. This is an opportunity to review the potential merits of NUA, because once the qualified plan is moved to an IRA, the opportunity for NUA is lost. Only distributions from qualified plans [e.g., 401(k)] qualify as “lump-sum distributions” and so once the employer securities are in the taxpayer’s IRA, they cannot take advantage of the NUA rules.

Income Tax Reporting and Compliance

In the example above, when John transfers the employer securities in-kind to a taxable brokerage account, he could sell the securities immediately and the NUA gain would be treated as a long-term capital gain. Even if the positions were not held for more than a year and a day, it is afforded long-term capital gain treatment. Any post-distribution appreciation is a short-term capital gain if the stock was not held for more than a year and a day.

For the year of the lump-sum distribution, John will receive a Form 1099-R with the total distribution box checked in box 2b. The form will also show the NUA of $750,000 in box 6, and the gross distribution in box 1 will include $1,000,000. The taxable amount in box 2a will include the $250,000 of cost basis. There is no mandatory 20% withholding for the lump-sum on the employer securities, but there is on any other cash or assets that may have been distributed. Because the distribution of the employer securities does come with a tax, it is necessary to consider whether there is sufficient outside cash to cover the tax liability.

There is an exception for net investment income tax purposes (imposed at a rate of 3.8%) for distributions from qualified plans. The capital gain on the NUA is not included in “net investment income” for purposes of the net investment income tax under Treasury Regulations § 1.1411-8(b)(4)(ii). CPAs may need to adjust or override their tax software to get that result for the capital gain entered from the 1099-B. It is important to note that any appreciation in value in the employer securities after the distribution from the qualified plan is included in net investment income and can be subject to the 3.8% tax.

Income in Respect of a Decedent

In general, an heir may receive a step-up in cost basis for property included in the decedent’s estate at death under IRC § 1014(a). IRC § 1014(c) provides an exception, however, for property that constitutes a right to receive income in respect of a decedent (IRD) under section 691. In the above example, if John dies after the lump-sum distribution and still owns the employer securities, then there is no step-up in basis for the NUA portion (see Revenue Ruling 75-125 & CCA 92-47). Any appreciation after the lump-sum distribution may receive a step-up in basis. Revenue Ruling 69-297 also holds that net unrealized appreciation in the securities of the employer is includible in gross income as IRD of the decedent in the taxable year of their disposition by either the executor or the residuary heirs, and a 691(c) deduction is allowed for any estate tax attributable.

NUA Planning

NUA is not an all-or-nothing decision. A plan participant could decide to distribute a portion of their employer stock in-kind and roll over the rest to an IRA when taking this lump-sum distribution. It is easy to get caught up by preferred long-term capital gains rates, but the basis distributed is subject to ordinary income tax, and that could substantially increase one’s income tax liability. In general, NUA is attractive if the employer stock has low basis and there is a large gain, because only the basis is subject to tax, while the NUA is deferred until it is later sold.

While this article addresses the tax considerations for NUA, retaining and holding onto employer stock is also an investment decision that should be handled by the plan participant’s investment advisor. There could be a strong case to sell all of the employer stock or delay the sale and dispose of it more systematically.

In the example above, John was 57 years old when he took the lump-sum distribution. What if John was 27 years old? At such a young age, there could be a stronger argument to roll over most of the employer stock to an IRA, where there could be continued tax deferral for close to 50 years before beginning required minimum distributions (RMD). Conversely, what if John were 77 years old? At that age, John is likely subject to RMDs from the plan and those are taxed as ordinary income, which could make for a more compelling argument if capital gain rates are lower than his effective ordinary rate. Plan participants must also be cognizant of RMDs that need to be taken first in the year that they take a lump-sum distribution.

What may deter many from pursuing NUA is dealing with the income tax due on the cost basis. Those inclined might entertain donating their employer securities to charity, or possibly to a charitable remainder trust (CRT). A CRT could provide a charitable deduction for income tax purposes, which can alleviate the tax paid on the shares’ basis. In addition, the income tax can be deferred and paid as distributions are received from the CRT. Lastly, for those concerned about creditor-protection, there is a level of anti-alienation protection lost when the employer securities leave the plan and are instead held outright in an account.