Retirement Investments and NUA Tax Treatment
By Mike Rahn, CISP
An unavoidable consequence of saving for retirement on a pretax basis is that a saver will eventually be taxed on such accumulations. Before Roth features in 401(k), 403(b), and governmental 457(b) plans existed, the vast majority of contributions to employer-sponsored retirement plans were made on a pretax basis. Such amounts saved, and subsequent earnings, remained tax-deferred until distributed from the plan.
Some who save in corporate-sponsored retirement plans have had the opportunity to invest not only in mutual funds, annuities, and other arms-length investments, but also in securities issued by their employer. While diversification is important in every retirement plan account, it is especially relevant where employer securities are concerned. It can be unwise to have your job and your retirement security both dependent on the same organization’s solvency and performance, as Enron employees discovered when the energy company collapsed in scandal and bankruptcy in 2001.
Still, there are circumstances that may justify investing in employer securities. In addition to having a stake in the sponsoring company’s success, and apart from hoped-for positive investment performance, a participant may eventually receive preferential tax treatment when employer securities are later distributed from the plan.
The Special Tax Benefits of NUA
Most pretax retirement savings are taxed as ordinary income, taxed at one’s marginal tax rate. But under specific circumstances employer securities can be taxed differently. If these conditions are met, the growth in value of the employer securities can be taxed as “long-term capital gains.” This rate can be lower than a taxpayer’s marginal tax rate, especially for high income individuals or couples. The common term for this special tax treatment is net unrealized appreciation, or NUA.
In a typical NUA scenario, an individual distributes employer securities from his retirement plan account, in-kind. These securities are retitled from their status as plan assets and become assets held personally by the individual as retail brokerage investments. When this happens, the cost of these securities at the time they were purchased—the basis—is taxed as ordinary income in the year they become nonqualified retail investments. The securities’ growth in value will be taxed differently.
When the employer securities are eventually sold, they will be taxed at capital gains tax rates. To make things just a little more complicated, there are two time periods to consider when determining these capital gains taxation rates.
The growth in value between the date of original purchase and when the securities were distributed from the plan and became personal assets will be taxed at long-term capital gains rates. These rates currently are 0 percent, 15 percent, or 20 percent, depending on a taxpayer’s income and tax filing status. With a maximum capital gains tax rate of 20 percent, it’s evident that some taxpayers—those in higher tax brackets—can benefit significantly from the NUA option.
What about growth in value that may occur after the securities have become nonqualified , personal assets? If the value of the employer securities continues to grow, this additional growth will be taxed as either long-term or short-term capital gains, depending on how long the taxpayer continues to hold them.
Short term capital gains are those that accrue over a period of one year, or less. That rate is the same as a taxpayer’s marginal tax rate, which is based on one’s overall income. If held longer than one year, the post-distribution growth will be taxed as long-term capital gains, at the rates noted above.
Who is Eligible for NUA Tax Treatment?
The retirement plans that can potentially offer a participant the opportunity for NUA tax treatment of employer securities investments include qualified pension, profit sharing, or stock bonus plans. Not included are IRA-based SEP and SIMPLE IRA plans, or an IRA itself. Furthermore, employer securities rolled over in-kind to an IRA can never qualify for NUA tax treatment. (Because a SIMPLE 401(k) plan is, in fact, a component of a profit sharing plan, such plans—though perhaps relatively few—could potentially afford participants this opportunity.)
Not everyone who invests in their employer’s securities becomes eligible for NUA tax treatment. It is available to employees at age 59½, upon becoming disabled, after separating from service with the plan-sponsoring employer, or to a beneficiary upon the death of the participant. A self-employed individual who becomes disabled within the meaning of Internal Revenue Code Section 72(m)(7) is also potentially eligible for NUA tax treatment.
Perhaps the most important factor in exercising an NUA option is meeting its lump-sum distribution requirement. This is met if a plan participant takes a full distribution of all assets in a retirement plan within one tax year. Partial distributions within the same tax year that account for all of a participant’s plan assets would satisfy this condition. (Under some circumstances, a participant in multiple retirement plans sponsored by the same employer must aggregate them when determining if the lump sum distribution requirement is satisfied.)
It’s important to emphasize that the relevant period is a tax year, not simply a 12-month period. Most taxpayers have a calendar tax year, and—if so—the cumulative distributions must all take place within the same calendar year. For example, partial distributions taken in December of one year and January of the next would not meet this condition for most taxpayers.
In-Service Distributions and NUA
What about in-service distributions, for which some participants qualify during their time of employment, perhaps long before age 59½ or retirement age? Do partial in-service distributions taken before age 59½, or before separation from service, make future NUA treatment unavailable to the participant or a beneficiary?
Fortunately not. But reaching certain distributable events does set in motion the lump sum distribution requirement. For example, once the participant reaches age 59½ or, if later, separates from service with the plan-sponsoring employer, any subsequent distributions must satisfy the lump sum condition for NUA tax treatment to be available.
NUA treatment is also available to a beneficiary upon the death of a participant if the lump sum distribution requirement condition is subsequently met.
Summary
NUA tax treatment is not an option available to all who participate in an employer-sponsored retirement plan. But for those who invest in their employer’s securities through such a plan, it may be an option worth exploring.
