In many large (publicly traded) businesses, it’s common to reward employees with employer stock, often granted directly in/through a profit-sharing or ESOP plan, or at least by allowing employees to purchase shares themselves inside of their 401(k) plan. The advantage of this strategy is that it helps to encourage an “ownership mentality” of the employees – who literally become (small) shareholders of the business. The disadvantage, however, is that when employer stock is purchased/owned inside of a retirement account, it is ultimately taxed as ordinary income when withdrawn (as is the case for any distribution from a retirement account), and loses the opportunity to take advantage of favorable long-term capital gains rates.
To help resolve the situation, though, the Internal Revenue Code allows employees a special election to distribute appreciated employer stock out of an employer retirement plan, and have the “Net Unrealized Appreciation” (i.e., the embedded capital gain) taxed at favorable capital gains rates outside of the account. However, to take advantage of these special NUA rules, there are specific requirements – that the stock must be distributed in-kind, as part of a lump sum distribution, after a specific triggering event.
The good news of the NUA strategy is that it creates an opportunity to convert unrealized gains from ordinary income rates into lower tax rates on long-term capital gains instead. However, the caveat is that in order to use the NUA rules, the account owner must report the cost basis of the stock immediately in income for tax purposes, and pay taxes at ordinary income rates. In addition, if the NUA stock is quickly sold, that long-term capital gains bill immediately comes due, too.
Which means in reality, the NUA rules don’t merely allow for the gains to be taxed at lower rates. They cause the gains to be taxed at lower rates immediately (at least if the stock is sold immediately), in addition to triggering ordinary income taxation of the cost basis immediately, when all of those tax liabilities might otherwise have been deferred for years or even decades. Which means deciding whether to take advantage of the NUA strategy or not is really more of a trade-off, than a guaranteed tax savings success.
As a result, the best practice for NUA distributions is to really scrutinize the cost basis of the employer stock inside the qualified plan, and if necessary cherry pick only the lowest-basis shares for the NUA distribution to ensure the most favorable tax consequences. Fortunately, the NUA rules do allow such flexibility – to take some shares in-kind, and roll over the rest – but that still means it’s necessary to actually do the analysis to determine whether or how many of the NUA-eligible shares should actually be distributed to take advantage of the strategy (or not)!