NUA – What Is Net Unrealized Appreciation?
NUA or net unrealized appreciation is the rise in the value of an employee retirement plan when a lump-sum distribution is made into a taxable account. Instead of being taxed as regular income, the difference in value is taxed at long-term capital gains rates. For example, employees can roll over a portion of their 401(k) investment in company stock to a brokerage account. Then, they pay tax at more advantageous long-term capital gains tax rates rather than higher ordinary income tax rates. This is the key advantage when the shares are sold under the NUA – net unrealized appreciation rules.
Under the NUA rules, former employees can elect to defer taxes on the NUA until the time they liquidate the stock. The NUA should be taxable as long-term capital gains. This is regardless of how soon they sell the stock after they receive it in kind. Also, NUA and any additional appreciation realized after the distribution in kind should not be subject to the 10% early withdrawal penalty. This is regardless of the client’s age. However, the additional appreciation should be taxable as short-term or long-term gains. Of course, this depends on how long the client held the stock after it was distributed in kind from the plan.
NUA – A Closer Look at Net Unrealized Appreciation
Many employees are able to purchase stock in the firm for which they work as part of an employee benefits package. One option is to own stock in a firm through a 401(k). However, upon receiving distributions, such assets will be subject to capital gains tax. Applying net unrealized appreciation (NUA) to such payouts may assist in securing a reduced capital gains rate on the sale of company shares. It is worth considering for any employee with corporate stock in a workplace retirement plan. Simply put, NUA may be able to assist in saving money on investment taxes.
Distributions from tax-deferred retirement funds are typically considered regular income at the time of distribution. Ordinary income is taxed more than long-term capital gains. To address this issue, the Internal Revenue Service (IRS) provides an option for employer stock NUA to be taxed at a lower capital gains rate. The NUA election is only available when the stock is deposited in a tax-deferred account. For example, a 401(k) or conventional IRA. Also, it is only applicable to shares owned by the firm for which you are or were employed. Roth IRAs are not eligible for NUA because they are not tax-deferred. Likewise, brokerage accounts are not eligible for NUA since they are normally liable to capital gains tax.
Cost Basis
The cost basis of the shares is the amount you paid for them. Assume that the entire cost basis of the shares you possess is $50,000. When you retire and distribute the shares in kind as a lump payment, you will pay tax on the cost basis at your regular income tax rate. This implies that you would record $50,000 of income as a pension distribution on your tax return in the year of distribution.
NUA – Net Unrealized Appreciation
If the total value on the day of distribution is $150,000, and your cost basis is $50,000, the NUA would be $100,000. Normally, you do not have to pay taxes on the net unrealized gain until you sell the stock. Even if you sell it straight away, it will be taxed at the long-term capital gains rate at that time.
NUA – Advantages and Disadvantages of Net Unrealized Appreciation
According to IRS laws and regulations, distributing stock from a 401(k) has varied implications on NUA funds. For example, the IRS will tax the bulk of a 401(k) portfolio as ordinary income at its market value. However, shares of employer stock will only be taxed as regular income on a cost basis. The initial value of the employer stock is the cost basis.
- Capital gains vs regular income tax – The additional value earned after the stock was first purchased is taxed as capital gains rather than regular income. So, when the employee sells the firm shares, it will be subject only to capital gains tax. Ultimately, this may be significantly lower than their existing income tax rate.
- Cost basis is still taxed as regular income – The downside is that ordinary income tax must be paid on the cost basis of the employer stock immediately. The trade-off is that ordinary income taxes would not have been due until you sold the shares in the future. Usually, at retirement years or decades from now. Because of this trade-off, it is best to only distribute the lowest cost basis shares under the NUA rules. This helps to optimize the tax consequences.
Requirements for Net Unrealized Appreciation
As part of the NUA guidelines, there are extra conditions that must be satisfied. You must distribute the whole vested amount maintained in the plan within a single year. This includes all assets from all accounts sponsored by the same company. A number of qualifying events must also be completed. You must have left the firm, achieved minimum retirement age, been injured and rendered totally disabled, or died.
- Stock distributed in kind – The stock owned by the employee must be transferred directly to a taxable investment account. Distribution in kind is a payment made in the form of securities or other property rather than in cash. Employees are not allowed to sell shares and transfer the cash or use stock options or repurchases. The NUA tax treatment will not hold for the options.
- Lump-sum distribution – should be made by the employer retirement plan. Under such a condition, the complete account balance of the retirement plan must be distributed over a single tax year. No amount can stay in the plan after the distribution.
- Triggering event– The distribution must be made after a triggering event in order for the preceding two requirements to hold. A triggering event might be defined as death, disability, service termination, or attaining retirement age. As a result, if a person is working and no triggering event has happened, a stock will not qualify for NUA treatment.
Final Words
If you own shares of your employer’s stock in a workplace retirement plan, NUA might be a beneficial tax planning tool. When employing this tactic, there are certain guidelines to follow. Therefore, speaking with a tax professional about the best way to approach it may be beneficial. Ultimately, it depends on how much your firm stock shares have appreciated in value. Another factor is how long you intend to keep them. In either instance, NUA might dramatically reduce your tax burden.
Up Next: What Is Cash on Cash Return?
Cash on cash return (CoC) is a rate of return metric that is commonly used in real estate investments. It compares total cash earned to total cash invested. The ratio can give you an idea of your property’s potential, but it is limited in a few key ways. This calculation ignores specific tax situations and does not account for appreciation or depreciation. No metric can predict the future and CoC is no exception. For example, it can’t tell you what will happen if there’s a fire or a flood, or what long-term expenses you’ll face. Also, it can’t tell you how much profit you’ll make when you sell the property. However, it can give a good idea of the potential return on your cash outlay. Of course, this assumes your input numbers are correct and no unexpected outlays or extraordinary events come up.
Cash on cash return is one of several metrics used by real estate investors. It is a tool to assess the current or future profitability of an investment property. The calculation compares the net income generated by a property to the initial cash investment required to purchase that same property. In other words, cash on cash return indicates how much of your out-of-pocket investment you earn back each year. It compares the annual return made by the investor on the property to the amount of mortgage paid during the same year. Due to its simplicity, CoC is regarded as one of the most important real estate ROI calculations.
