The tax code is littered with little-known rules that apply to only a very small set of people at certain periods of time. These rules, however, can have substantial benefits for those impacted. Today, I am going to discuss a situation that will affect anyone who is currently acquiring company stock as part of their retirement plan. You don't need to completely understand the rule, but you do need to at least be aware that you have options that could keep thousands of dollars in your pocket and away from Uncle Sam's donation bin for the careless!
Many employers give their employees stock as a financial perk or allow them to purchase the stock at a 10-15% discount from the publicly traded rate. These benefits are designed to help keep the employee invested in the company's broad success, beyond their specific role. The hope is that the company stock will appreciate in value at a much higher rate than other investments might. Should you be in the position where you have accumulated company stock and have seen it rise dramatically in value, considering this tax rule is prudent.
The crucial part of this concept is to understand the difference between "ordinary income tax rates" and "capital gains tax rates." Ordinary income tax rates are the brackets you are most familiar with. These range from 10% to 39.6%. Capital gains tax rates apply to dividends and long term capital gains- these are either 15% or 20%, as the Net Investment Income tax of 3.8% does not apply here. If your income tax bracket is higher than your capital gains tax rate, and your stock has appreciated in value, the NUA election could be for you.
Let's say that several years ago, you acquired shares that amounted to $10,000. This is your cost basis in the stock. Today, it has grown to $100,000. Thus, you have a gain of $90,000, which is your Net Unrealized Appreciation- NUA. Now, you are either leaving the company who holds this stock OR have reached age 59.5. This is also relevant if you are the one inheriting these assets.
Here's what most people do: they roll it all into an IRA because they do not know about this rule. What that means is that when they take distributions from their IRA, they will pay taxes on the full $100,000 balance at their income tax rate. Let's call that 33% for today. If we are talking about a retiree who will be slowly drawing this money out for decades, keeping it in the IRA may be the right move as it would enjoy tax-deferred growth.
However, this event can provide an opportunity for some MAJOR tax savings if you intend to use that $100,000 in the near future:
Here's how it works. When your plan is distributed, you must distribute all assets from all qualified plans at your former employer, not just the one that held the shares of stock. These will go into an IRA. Your company stock will be held in a taxable brokerage account, and you will pay taxes on the cost basis: $10,000 x 33% = $3,300.
Now, that company stock is treated just as if you had bought any other company in the taxable account. When you sell it, you will be subject to capital gains taxes, 15% x the $90,000 gain = $13,500. You could sell this tomorrow, or wait several years, but you won't pay that tax until you sell the stock. As illustrated above, this move saves you $16,200 in taxes. The NUA election is more attractive if distributions are to be taken in the near future, such as to live off of, buy a home, start a company with, etc.
As with anything, there are many factors to consider when evaluating this maneuver: how long will the money in the IRA be able to grow before a withdrawal is made? What tax rate will apply at that time? If this $100,000 is excess cash to an already established retirement plan, a lump sum today may not be desirable.
Of course, my favorite calculator website, CalcXML, can help you consider several variables when making this decision, but I would not try making this election yourself without consulting a financial planner. Having a second look at your holistic situation is crucial so that you are not forgetting certain factors, such as having enough cash on hand to pay these tax bills!
Your human resources department is not likely to make you aware of your choices, and unless you have an advisor who is trained to watch out for these issues, you could miss out on thousands of dollars worth of hard earned money without ever knowing it. If this situation pertains to you, contact Alex@fncadvisor.com.