Net Unrealized Appreciation Q & A… And… Comments…

COMMENT: When considering an NUA, an important consideration aside from whether you qualify, is whether you are disqualified. For example, you are allowed only one distribution in the year of the NUA lump-sum distribution. Accordingly, a loan can disqualify you. Furthermore, you should consider when to make the lump-sum distribution. For example, assuming you retire in the beginning of the year, say Jan 2, 2018, or the next day back to work, you would potentially have all of 2018 and all of 2019 to take the distribution. So if you had a disqualifying event in 2018, you could potentially wait until 2019 to take the distribution. With that being said, its also important to note that the NUA rules permit you to allocate which company stock you’d like to distribute to the taxable brokerage account and which you’d like to rollover with the other assets to the IRA. So it’s worth considering if it makes sense to retain some of the stock. Finally, consider your options as to how and why you should liquidate the NUA stock after you’ve distributed it. Many people don’t realize that there are three capital gains rates: 0% 15% and 20% and that the NUA avoids the Net Investment Income Tax of 3.8% NIIT. So your TOTAL income determines your capital gains tax bracket–Not just your capital gains sales. Also, you could consider whether liquidating other stock from the account could offset some of the gains. Please seek tax advice and have a professional tax advisor consider your options.

Q: If the company is being acquired in a cash deal, would that qualify as a triggering event, AND, should the lump sum distribution occur before the acquisition? In this case, separation of service occurred in 2016, participant is age 55, and has kept the 401k with former employer, which is now being acquired.

A: Hi, let me preface that tax counsel should be sought but generally: The triggering events are (a) Death, (b) Disability, (c) Separation from Service, or (d) Reaching age 59 ½. Notably, this means that an in-service distribution generally does not qualify for NUA treatment, unless it is a distribution that also happens to occur after a triggering event (e.g., upon reaching age 59 ½). So perhaps the acquisition is not a triggering event, generally speaking. I am not aware of any authority for that. So if the separation occurred in 2016, the person would have until the end of the subsequent tax year 2017 to make the NUA distribution. The problem I’ve encountered with clients like this is they’ve taken a distribution in the current year, which could make them ineligible. If the client made a distribution in the prior year, they might still be eligible, as long as no distribution in the current year. Loans also make them ineligible. So the caution and big warning is make sure you seek tax counsel to determine whether the client is eligible. Ive had scenarios where we had to unwind an NUA, which I know how to do, but that’s beyond the scope of the article.

Q: In regard to the “entire balance in a single tax year lump sum” requirement, would an in-service distribution to an IRA at age 59-1/2 affect the ability to use NUA treatment of company stock at age 65 retirement?

A: Hi, if you qualify and make the distribution, bear in mind you need to make a lump sum distribution. So you would be effectively liquidating your 401k. Thus, I had a client go back to the same firm after retiring. The question raised was whether he would be eligible for the NUA a second time and I believe I opined yes, but I’d recommend retaining tax counsel. In other words, I see no reason why not but I’d have to see the mechanics of it, because right now it’s a pure hypothetical exam question. The warning I routinely give is — it’s not only whether you qualify for the NUA, it’s really whether you have something that disqualifies you. Good luck.

Q: I have to start taking RMD this year and am planning to rollover my 401K into an IRA. Say I rollover everything in my 401K to an IRA except for the company stock which I transfer in kind to a brokerage account. I must pay ordinary income tax on the RMD AND on the cost basis of the company stock. Every year going forward, I must pay ordinary tax on the RMD and any time I sell some of that company stock, I would have to pay long-term capital gains tax on that sale. Which sounds like double taxation to me. The longer I hold that company stock, or the more slowly I sell shares to limit the tax consequences, the more I’m locked into a stock position that may not be advantageous. If I sell the stock all at once outside the IRA, there’s a huge capital tax gains on top of the RMD. I just don’t see the advantage.

A: The NUA would count as an MRD. You may not be grasping the concept. An example to help. If the FMV of the stock is $20–assume you pay as much as 39.6%, or ($8) tax on every share if you do not do an NUA. If your basis in the stock is $12, you pay 39.6%, or ($4.80) on the basis of $12, and pay 0%, 15%, or 20% or ($0, $1.20, $1.60) tax, on the NUA part of $8. So would you rather pay tax of ($8) or ($5.40) per share of tax in this scenario? Obviously you’d like to pay less so you would choose an NUA. Now multiply that by 100 shares, 1,000 shares, 10,000 shares. You save $2 bucks/share in taxes x 10,000=that’s $20,000! To determine whether or not to sell the stock, that decision should be made jointly with the financial adviser. Please immediately seek tax counsel as if your financial future depended on it! Good luck and great questions.

COMMENT: A Minimum Required Distribution (MRD) often called a Required Minimum Distribution or RMD is a mandatory distribution from an IRA at 70 1/2 years of age. If you are eligible for the NUA and it makes financial sense and tax sense, and you’ve had tax counsel model your tax exposure and discussed it with your family, then the distribution of the NUA stock counts as an MRD or RMD at its fair market value, FMV, except you only have to pay tax on the basis of the NUA stock, not its FMV. If the FMV of the NUA stock is insufficient to satisfy your MRD for the year (which by the way you must have one heck of a large retirement account like Mitt Romney’s $100,000,000.00 IRA) then you could satisfy the balance of the MRD by taking a taxable distribution from the newly rolled-over IRA. You would pay ordinary tax. The alternative is not to do an NUA and roll the whole 401k to an IRA. In this case you would pay ordinary income on the entire MRD. So isn’t it clear how you save money with the NUA? You pay ordinary income only on the basis and pay long term capital gains rates, 0% 15% or 20% on the NUA and avoid the 3.8% NIIT if applicable to you. So what happens is if the basis of the stock is say $12 and the FMV is $20, then the NUA is the difference or $8, which is taxed at long term capital gains not ordinary tax rates. The taxes on the NUA are simply deferred until you sell the stock. Please seek tax counsel so you can have your personal situation explained to you. I usually prepare a financial model to show you how much tax you would pay in both scenarios so you understand. As such I recommend you do this.

Q: The stock transfer does not count as an RMD. I still have to take the RMD, pay taxes on it AND pay taxes on the cost basis of the stock. Going forward, every year I must pay taxes on the RMD and, if I sell any of the stock, taxes on the capital gains. If I convert the entire 401K, including stock, into the IRA, I pay taxes on the RMD every year. But there are no taxes on capital gains because there is no stock in a brokerage account. In other words, in Case I, I am paying taxes on both the RMD and the stock and every time I sell the stock I pay taxes on it. In Case 2, I simply pay taxes on the RMD. “Double taxation” is perhaps the wrong way to describe this. What I see is that I will end up paying more taxes by using the NUA as well as put myself at a long-term risk from ownership of the company stock which is too high for my comfort. Selling the stock all at once in the brokerage account, as many sites suggest, would result in a huge tax bill. If I needed the cash, it might make sense, or if I were 40 years old, the NUA might make sense. But I don’t see how it makes sense for somebody who is required by law to take an annual RMD when they do they 401K->IRA rollover. I’m truly not trying to be argumentative for the sake of argument. I’ve got to decide what to do in the next month, and I need to understand the NUA to make the right decision.

A: In addition to my other contributions below, I wanted to add one VERY IMPORTANT point to paragraph (2) The Employer retirement plan must make a ‘lump sum distribution’ in a single tax year…a plan participant may NOT have any other distributions from the plan during that year or it would likely disqualify the NUA special treatment. Traps: a partial distribution earlier in the year, or even a loan. This would not be a non-lump sum distribution during a single tax year, even if the NUA lump sum distribution was attempted later in the year. Be wary of this point and seek tax advice immediately.

Q: I have a question related to RMDs. It is my understanding that you can use the market value of the stock to satisfy the RMD, but still only have the cost basis as the taxable amount of the distribution. So, $2 million 401k, around $73,000 RMD. Company stock market value in 401, $65,000, cost basis $10,000. I do NUA plus $8,000 and my RMD is satisfied, but the taxable amount comes to $18,000. Is this correct?

A: You are getting into a level of genius that warrants applause. If this strategy works, you effectively satisfy a required minimum distribution requirement, while deferring the recognition of income, and with the NUA, you are also deferring and reducing your tax rates. Bravo.

Q: Can you sell high cost basis shares in the 401k, diversify those proceeds and then roll out the remaining low cost basis shares into a taxable account and roll over the remainder to an IRA?

A: Yes, generally speaking, one could liquidate shares prior to the NUA rollover, or one could simply roll-over the account to an IRA and do it there. I suggest you speak to a tax advisor.

Q: However, there is a step-up on death for any appreciation that occurs after the date of NUA. Shouldn’t that have been calculated into some of your analysis?

A: Usually people separate in the beginning of their retirement, but it is possible to separate for health reasons. In my mind, the step-up in basis is a bonus to the NUA, as otherwise an heir would inherit an IRA subject to ordinary tax rates. So if the NUA was viable to begin with, then perhaps to the extent the NUA is not subject to tax, it’s truly a tax-free gift. –ADDED: The article indicates that the NUA is “not eligible for step-up in basis at death…” in the paragraph before example 2 (citing Rev.Rul.75-125). In Rev.Rul.75-125, a decedent died holding company NUA gain stock in his qualified retirement plan. His widow elected the NUA and subsequently sold the stock. As a result, she was not entitled to step up in basis. However, there’s nothing in my research to suggest that the NUA once performed in life, would not receive step up in basis post death. So I wanted to clarify that point.

Q: Do you know if you can allocate after-tax money directly to the cost basis? For example, if you had a $2mil IRA with $1mil of NUA stock (cost basis $200k). If there was $100k of after-tax dollars, could you roll $1mil to an IRA, do a transfer of stock to a taxable account for the remaining $1mil and only pay tax on $100k ($200k less $100k basis)?

A: Yes, I believe this is an option if you qualify. Otherwise you could go with rolling it to a Roth if that benefits you. If not, then use the money to pay the NUA bill. Brilliant. Seek tax counsel to ensure you qualify.

Q: Any thoughts on how the company must calculate basis? Someone below mentioned using average basis, but is it really as simple as the stock purchase price? I thought I had read a while back that employers used a formula of some kind.

A: The plan administrator of the 401(k) or ESOP or LESOP will calculate your basis for you. If it does not then it is possible to recalculate, and I’ve done it by using prior statements or pay stubs. But it takes a long time because I had to go through every statement over the course of many years.

Q: if this is a private company (and about 90% of ESOPs are private companies), how does the in-kind stock transfer work? Will a brokerage accept private stock? And wouldn’t there have to be a repurchase agreement with the company on these shares?

A: Technically speaking, most custodians may not accept private stock unless conditions are met but you could ask them. You may not be required to distribute the NUA stock to an account per se, you could simply hold them in bearer form for example. As far as a repurchase agreement, that’s not a requirement that I am aware of. Please seek tax counsel and speak with the ESOP trustee. It is the Trustee who could provide the stock basis and report the NUA on a 1099-R to the IRS.

Q: What are your thoughts on the “Frank Duke Method” of NUA distributions? (Frank Duke was a former P&G exec that implemented an approach whereby at the end of the day through a series of transactions (exchanges from Preferred Stock to Common Stock etc.) a high basis is allocated to stock rolled out to the employee and the remaining shares without basis are rolled into an IRA.)

A: My thought on the Frank Duke method was it’s brilliant. Essentially it involves changing the accounting method of the NUA stock from, say for example, “FIFO” First In First Out, to either specific identification, or weighted average. So by changing the accounting method, you can effectively change the basis of the individual shares of stock. In other words, if you have a basket of stock that was purchased during rising stock prices, the stock purchased later has a higher basis. By changing the accounting method, you can say that the first share sold is the low basis stock. And obviously, the stock is then distributed in part to the taxable account and part to the IRA, with different basis. So this works when there are baskets of stock and multiple purchase prices. Keep the high basis stock in the IRA because you’re not getting much benefit from the NUA. Roll out the low basis stock. So it’s obviously brilliant. I have helped clients do this in the context of charitable giving, so it’s certainly possible with the NUA. I would recommend hiring tax counsel though.

Q: Would the NUA option be more attractive if someone plans to make annual charitable contributions throughout their retirement years? I’m thinking it might make sense to take an NUA-eligible distribution and then donate a portion of the shares to charity each year, with the assumption that the charity would get the full value of the shares at the time they were donated and donor wouldn’t owe any capital gains tax on them. What about another possibility: Could the entire NUA-eligible distribution be donated to a donor advised fund (after the shares were placed in a brokerage account) without incurring any capital gains tax?

A: If someone asked me this I would ask them to consider a QCD Qualified Charitable Distribution, which also satisfies your required minimum distribution RMD. Perhaps its feasible to pay tax on the NUA and subsequently donate the appreciated shares in-kind taking a schedule A charitable deduction. A financial analysis should be done to determine the tax efficiency versus a QCD.

Q: I have 4 questions. please help me understand? (1) What happens to NUA if stocks are still in 401K plan and the company is acquired by another company with 50% cash and 50% stock deal? Does opportunity for NUA goes away? (2) How cost basis and taxes would be reported if after NUA transaction(in-kind transfer), the current stock is acquired by 50%cash and 50% stock deal with a new company. Do you loose the long term cap g/l tax advantage? (3) After the NUA transaction, isn’t you cost basis for the transferred stocks in brokerage account = o since you have already paid ordinary taxes on the cost basis? (4) I don’t understand the crossover/breakeven point graph. Why rollover IRA (with cost basis of say 10% and 62 years of age employee) ever overtake the NUA distribution assuming same investment assumptions.

A: 1)    What happens to NUA if stocks are still in 401K plan and the company is acquired by another company with 50% cash and 50% stock deal? Does opportunity for NUA goes away? It depends. If you make a distribution before the transaction, then perhaps the NUA can be completed. The other consideration is whether the new stock is employer stock? Is the employee employed by this new company? If you do not make the distribution, then the question is whether you still qualify for the NUA and if it is employer stock. (2)       How cost basis and taxes would be reported if after NUA transaction(in-kind transfer), the current stock is acquired by 50%cash and 50% stock deal with a new company. Do you loose the long term cap g/l tax advantage? The custodian tracks the basis in the 401(k). But it can be re-calculated if needed and I have done it. (3) After the NUA transaction, isn’t your cost basis for the transferred stocks in brokerage account = o since you have already paid ordinary taxes on the cost basis? After the NUA, the cost basis of the stock is the same as the cost basis of the stock held in the 401(k). The cost basis does not change because of the distribution. (4) I don’t understand the crossover/breakeven point graph. Why rollover IRA (with cost basis of say 10% and 62 years of age employee) ever overtake the NUA distribution assuming same investment assumptions. This is because of appreciation of the stock, and the avoidance of capital gains taxes in the 401(k) and IRA accounts. They are tax deferred and do not pay capital gains taxes.

A: Firstly, your custodian should be able to tell you whether you have n u a stock in your account. However, your custodian or financial advisor is not going to be able to tell you the tax consequences of that transaction. In order to determine the tax consequences, someone needs to look at your prior-year return and forecast your current or expected income to determine the implications for tax purposes of an Nua rollover. Another important thing to consider about the NUA strategy is that although you may qualify, its important to make sure you don’t have a disqualifying event, such as a distribution or a loan from your 401k. As such, aside from analyzing the factors that qualify you, take a look at the tax implications of the lump sum distribution, how the distribution of the Nua stock is going to affect your taxes, and how much tax you’re going to owe in the current year. In addition, you need to know when to make your estimated tax payment. Furthermore, you should know what to expect from the custodian by way of documentation of the Nua stock. Moreover, you should be fully aware of the basis, or the purchase price of your Nua stock. The basis is important as is the accounting method by which you account for your transaction for income tax purposes. This means are you using first in first out, last in first out, specific identification, or weighted average methods. You should consider the consequences of selling all of your NUA stock, and distributing only part of your NUA stock to a taxable account, while rolling over the remainder to an IRA. If you choose this, you’re going to need to decide which lot of the stock you should roll over, if it benefits you to do so. In this regard, you can choose which accounting method to use that best suits you for the transaction. In conclusion you should also have some level of assurance from your tax consultant or Tax Advisor that would help you in the event the IRS chooses to examine your return or has questions about your Nua transaction.

Q: I am recently retired (at 76) and have a large amount of company stock in my 401k. Half has substantial gain (good for NUA) and half is near market value. Do I need to take all out to a non-Ira account or can I take only the portion that is relevant to NUA? I do not intend to sell the stock. In addition do I need to take a total rollover of all funds at the same time that I take the stock? I also have to take a required distribution.

A: I would advise a client that legally speaking, the IRS allows the basis of the stock to be allocated among the shares, so that you can distribute NUA stock in lots, as you see fit. But you would need a CPA such as myself to sign off on it, as well as the fact that you would need to be eligible for the lump sum distribution and otherwise not disqualified, as it needed to be done within 1-calendar-year following the triggering event. But if I understand your question, it is possible with the right support team. Also, under Treasury Regulations the NUA distribution counts as a Minimum Required Distribution for the Fair Market Value, not just the cost basis of the stock distributed in the lump-sum distribution/rollover. This is not advice, but rather a suggestion that you seek counsel.

Q: I am just over 70.5 years. I have executed a LSD from my company 401K including taking advantage of an NUA to pull out company shares and satisfy the RMD. The shares have transferred from the 401K to the share holding company. The shares are registered to my name as individual (because the 401K was only in my name – with my wife as beneficiary). Is it wise and acceptable to re-register the shares as Joint Tenant with Right of Survivorship? Will re-registering violate any rules of the NUA?

A: I would advise the client to seek a legal opinion as it may depend upon whether you reside in a community property state and what your estate plan calls for. You can’t re-register the ownership of your new IRA; you only may name a beneficiary. When you re-title your taxable financial account holding the NUA gain stock, you presumptively make a gift of the shares to all those on the title. The value of the account has significance, as does your estate picture. It also may be a factor as to whether you are married filing jointly or married filing separately. Your tax consequence could change. Under Federal tax law, you can generally give an unlimited amount to your spouse. But as far as tax consequence, under a hypothetical scenario, gifting to your spouse generally has no tax consequence as far as gift taxes. Please seek a qualified tax and legal counsel.

Q: I am going to sell NUA stock I have had for 2 months. Can I claim a capital gains loss since the stock has dropped $6 per share. I know any gain since the distribution would be taxed as short term gain. But no website I have read ever mentions the reverse in their discussion.

A: Without providing direct advice, understand the general rules: upon the distribution of the NUA stock in a lump sum rollover, the basis of the stock is included in your ordinary income plus any applicable early withdraw penalty 10%. The Net Unrealized Appreciation is the difference between the basis and the Fair Market Value of the Stock at the date of the distribution. No matter when the stock was actually purchased, that part is ALWAYS long-term capital gain. Any subsequent gain is treated as a capital gain with the holding period beginning on the date of the distribution. So subsequent gains are treated as short term unless they are held for a year of more from the date of distribution. If the stock had a basis of $1, and had a FMV of $10 when distributed (NUA of $9), then if the stock went to $6, then the NUA would be $5. If on the other hand, the stock dropped below its basis to $0.50, then you would have a long-term capital loss of $0.50. This is precisely why people should engage a professional to analyze these matters prior to entering the transaction to see if it makes sense from all angles to do the transaction. I am sorry you did not have a good experience, if can be of help to you I would gladly assist. Good Luck!

COMMENT: First, the client must qualify in the fact that he or she is with 1 tax year of the qualifying event. Further, the client can’t have made loans or distributions from the account. Third, the client needs to analyze the tax consequence and make sure he or she has the funds available to pay for the NUA. Estimated tax payments need to be made, timely. Should the client be diversifying out of the stock position entirely? Also, is this an opportunity to utilize a charitable giving strategy. The client should not attempt an NUA without first retaining tax counsel to determine if the NUA makes sense.