How to help plan participants understand net unrealized appreciation

Does your direct contribution qualified plan include shares in company stock? If so, you’ll want to talk with your participants about tax strategies as their eligibility for distribution approaches.

Plan sponsors and financial professionals play a key role in helping participants access a greater proportion of their assets’ value as retirement income. In particular, they need to consider Net Unrealized Appreciation (NUA) as part of any tax strategy. Not considering the role of NUAs when participants receive distributions could result in higher taxes, meaning there will be a lower amount left to help fund their retirement.

Employees should be aware of their distribution options in advance so they can plan and anticipate the required steps they’ll need to take regarding NUA elections. 

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 essential, however, that all plan participants truly understand what “tax-deferred” means, and how it affects their qualified plan account as a source of retirement income.

When participants take a distribution from a qualified plan, most will pay taxes on the distribution at ordinary income tax rates — wherever the income from the distribution puts them in terms of tax brackets. For the 2023 tax year, those rates are as follows:¹

Participants will need to know this information for tax returns filed in 2024. 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

Plan participants with highly appreciated employer stock among their qualified plan assets can change their distribution strategy to take advantage of NUA. Doing so can help reduce the tax liability on their retirement savings.

For example, consider the following hypothetical plan participant scenario: 

• Chris acquired employer stock at a cost of $150,000.
• Its value grew to $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 for Chris.

Participants can make the most of the NUA opportunities with advance planning and education. Employees should anticipate taking specific steps when they become eligible for a rollover, which typically happens when they:

• Reach 59-½ years of age
• Separate from service (through resignation, termination, or retirement)
• Become disabled
• Become deceased²

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 properly executing the NUA strategy. Once executed, the plan participant may consider a variety of options to reinvest or annuitize the after-tax proceeds.

All that said, NUA isn’t necessarily the right answer for every investor. In cases where company stock has not been held for very 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

Each participant’s circumstances may vary widely, highlighting the importance of working with a financial professional to consider different strategies, review potential results and plan accordingly. Providing financial education and resources can help plan participants recognize when their situation may benefit from some professional help to get the most out of their retirement investments.

SOURCES
¹ IRS.gov, IRS provides tax inflation adjustments for tax year 2023, October 23, 2023.
² IRS.gov, Retirement Topics - Exceptions to Tax on Early Distributions, August 29, 2023. 

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