How to help plan participants understand net unrealized appreciation

If your direct contribution qualified plan includes shares in company stock, you’ll want to create opportunities to talk to older and/or long-term participants about tax strategies as their eligibility for distribution approaches.

Why? Because plan sponsors and advisors can play a key role in helping those employees get access to a greater proportion of those assets’ value as retirement income.

Failing to consider Net Unrealized Appreciation, or NUA, as a tax strategy can result in a higher tax bill and less left to help support their financial security in retirement.

For investors to take advantage of NUA election at distribution, they should be aware of the option in advance so they can plan and anticipate the required steps.

Let’s take a closer look at how NUA works, and the guidance a participant may need from a financial professional.

Tax-deferred is not the same as tax-free

Most qualified plan participants understand that their account balances have been tax-deferred and therefore will be subject to tax at distribution. It’s really essential, though, to make sure all plan participants truly understand what “tax-deferred” means, and how it affects their qualified plan account as a source of retirement income.

In most cases, when participants take a distribution from a qualified plan, they pay taxes on the distribution at ordinary income tax rates — wherever the income from the distribution puts them in terms of tax brackets. For 2022, those rates are as follows:¹

Planning for NUA could, in some cases, make a difference in a participant’s tax rate, leaving more dollars for their retirement income.

How NUA can reduce tax liability

To take advantage of NUA to reduce tax liability on retirement savings, plan participants with large holdings of highly appreciated employer stock among their qualified plan assets can change their distribution strategy.

For example, if a hypothetical plan participant acquired employer stock at a cost of $150,000 and it’s valued at $400,000 at the time of distribution, through NUA, the IRS will tax the $150,000 basis cost at ordinary income rates. The remaining $250,000 (value acquired through appreciation) is subject to a lower capital gains rate — a difference that could potentially equal thousands of dollars in retirement income.

To help these participants make the most of the NUA opportunity, it’s smart to offer education and planning in advance. Employees should anticipate taking specific steps when they become rollover-eligible, which typically happens when an employee:

• Attains 59-½ years of age
• Separates from service (through resignation, termination, or retirement)
• Becomes disabled
• Becomes deceased

NUA can also be an important option as participants near required minimum distribution (RMD) age. That’s because in addition to the savings on the appreciation of stock value, taking the NUA-eligible shares out of the account before the IRA rollover results in a lower non-qualified IRA balance. That can reduce the individual’s RMD requirement — and the taxes paid on those RMDs.

How to implement the NUA strategy

Executing the NUA strategy requires the shareholder to transfer shares in-kind to a non-qualified brokerage account. The shares are then sold with the brokerage account, making them available for diversification reinvestment as non-qualified assets. The following considerations must be taken into account:

1. The qualified shares must be transferred in-kind to the non-qualified brokerage account. Shares cannot be liquidated within the account prior to distribution.
2. The cost basis of the shares is subject to ordinary income tax rates.
3. The entire balance of the employer-sponsored retirement plan account must be distributed within a single tax year — but not all of it, necessarily, to the non-qualified brokerage account. The non-NUA eligible balance could be rolled over to a qualified IRA, for example, if the plan participant preferred to continue deferring taxes on the remainder.

It’s hard to overstate the importance of executing the NUA strategy correctly. Once it’s been executed, the plan participant may consider a variety of options to reinvest or annuitize the after-tax proceeds.

It’s also important to understand that NUA isn’t necessarily the right answer for every investor’s situation. In cases where company stock has not been held long, or the cost basis is relatively high, it may not have the same impact on taxes, RMDs or future retirement income. 

Financial education is a smart place to start

Different participants’ widely varying circumstances highlight the importance of working with a financial professional to review potential results of different approaches, choose the right strategy and plan accordingly. But financial education can help plan participants recognize when their situation may warrant professional help to get the most in retirement from their investments.

SOURCE
IRS.gov, IRS provides tax inflation adjustments for tax year 2022, November 10, 2021.

CMRS-4950276.1-0922-1024