Last month’s column about strategies that are overhyped to consumers generated several emails suggesting other strategies I should mention. As a refresher, my definition of “overhyped” is a strategy that gets a lot of attention but probably doesn’t have as big a positive impact as is touted, is likely to have a negative impact, or for which there are very few clients who can or will attempt to execute the strategy. The list is not to suggest that all are universally worthless. In the right situation, there can be benefits to be had.
Net Unrealized Appreciation
The tax rate on long-term capital gains is lower than the rate on ordinary income. Net unrealized appreciation (NUA) offers the ability to take gains on employer stock that would normally get taxed at ordinary rates when distributed from a retirement plan and get those gains taxed at the more favorable long-term gains rate.
You simply roll out the stock to a brokerage account and pay ordinary income taxes on the shares’ cost basis. From that point, you can sell the shares and pay long-term capital gain rates on the appreciation. It’s a pretty slick maneuver but we have only seen it work well a few times.
There are several factors conspiring to keep NUA utilization low. First is meeting the qualifications. One needs a “triggering event.” These are death, disability, separation from service, or reaching age 59½. When a triggering event occurs, the shares distributed in kind to a taxable account must be of actual stock so phantom stock, options and the like are not eligible.
Finally, other assets can be rolled into an IRA but the entire plan balance must be fully distributed in the same tax year. Distribute the shares in one tax year and roll the rest to an IRA in another and the entire value of the shares distributed is ordinary income, not just the basis.
The second set of sticking points surrounds the basis of the distributed shares. It is common for the basis to be large enough that the tax due on that ordinary income is higher than the client cares to pay. This immediate taxation is a deterrent, particularly if the distribution is made prior to age 59½ because unless an exception applies, the client will owe the 10 percent early distribution penalty.
Further, the client is taxed on the basis but gets no cash from the distribution and cannot have taxes withheld. The client must take the cash to pay the taxes from elsewhere because cash is received from the shares only when the shares are sold.
The best scenario is one in which the basis is low and the appreciation is large. Because you can cherry-pick only the lots with low basis for a distribution and roll remaining plan assets to an IRA, more people should be able to take advantage of NUA but that’s not the case. It has been a mixed bag regarding how many plan administrators have good records of the lot by lot basis and know how to facilitate a qualifying group of transactions.
Yet another significant factor is behavioral. We have found that many people whose company stock has done well enough to consider NUA, have a hard time selling the stock to diversify. The stock has been good to them for a long time and in their minds that trend should continue. They simply don’t see concentration risk as applicable to their company. Often, they will use the gain taxes that would be due on top of the ordinary income from the basis as an excuse to continue holding the stock.