The largest transfer of wealth in the history of our country has begun. Baby Boomers are retiring, and many have accumulated very large 401(k) or other qualified plans.
For some, a big percentage of their plan consists of highly appreciated individual company stock. The tax savings you can generate for your clients using the net unrealized appreciation (NUA) technique can make a significant impact on their financial and estate planning.
A costly mistake
Unfortunately, many retirees and advisors make a fundamental mistake: They roll the qualified plan, rich in employer stock, into an IRA. Often retirees and advisors assume rolling into an IRA is the only option available.
On the surface, this seems like the standard operating procedure, but if this option is exercised, you may cost your clients thousands of dollars in additional taxes that they should not have to pay.
NET UNREALIZED APPRECIATION OCCURS WHEN AN EMPLOYER-SPONSORED PLAN LETS THE EMPLOYEE BUY EMPLOYER SECURITIES AS PART OF THE QUALIFIED RETIREMENT PLAN.
How NUA occurs
NUA occurs when an employer-sponsored plan allows the employee to purchase employer securities as part of the qualified retirement plan. The IRS treats these securities held inside the plan differently from the way it treats other assets such as cash and mutual funds when an employee retires.
When the employee rolls over his qualified plan to an IRA, he has the opportunity to withdraw his employer securities and pay income tax on the cost basis (not the current value) and capital gains tax on the gain if he sells the employer securities. The cash, mutual funds or other investment accounts will roll over into the IRA and are not taxed until withdrawn. (See IRS Publication 575.)
Let’s use the following case study to explain this. Mr. Smith, age 65, has a 401(k) plan valued at $500,000. $250,000 is in mutual funds, and $250,000 is in company stock. The basis on the company stock is $50,000. Assume Mr. Smith is in the 25 percent federal income-tax bracket.
Option 1: The normal rollover approach
Mr. Smith rolls the entire account into an IRA. Any normal distributions he takes will be taxed in the 25 percent federal income tax bracket. At age 70, he will be forced to take required minimum distributions (RMDs) and pay taxes on these distributions in his then applicable (assumed 25 percent) tax bracket. (See IRS Publication 590.)
Option 2: The NUA rollover approach
Mr. Smith rolls the stock out of the 401(k) plan. The basis on the stock is $50,000, and he must pay ordinary income tax on the basis of $12,500 ($50,000 x 25 percent tax rate). The stock is transferred to a nonqualified account. No additional taxes are owed on the stock until he sells it. Assume he does sell the stock. He pays capital gains tax on the sale vs. ordinary income and is thus taxed at 15 percent (current maximum capital gain tax rate), not 25 percent. This creates an immediate tax savings of 10 percent. Shares sold under this technique are taxed at long-term capital gains tax rates (up to the NUA), regardless of the length of time between the roll-out and the sale of the stock and short- or long-term gains on any additional gain beyond the NUA based on the time of sale. If he does not sell the stock, there are no additional taxes beyond the ordinary income tax due on the rollout. All other remaining funds are rolled into an IRA.
Benefits of NUA
NUA offers many advantages. First, it will reduce your client’s overall tax burden on the 401(k) plan, and he can have the opportunity to use capital gains tax rates vs. ordinary income tax on $200,000 of the value of the account.
Second, by reducing the amount rolling into the IRA, you will reduce the RMD amounts when the client reaches age 70. RMDs are calculated on the year-end balance of the IRA. If you remove the value of the stock from the account, it will not be included in the RMD calculation. Third, capital gains tax rates are significantly lower than the current income tax rates.
These tax savings can be used to fund long-term care and other estate-preservation strategies, using funds that otherwise would have been lost to taxes.
This technique is designed primarily for those older than age 59. The early-distribution penalties apply to those who elect this option before age 59, and a 10 percent early-distribution penalty will apply. The approach may still be viable under these circumstances, as the penalty tax only pertains to the “basis” of the roll-out and not the full value of the stock.
NUA does not enjoy a “stepped-up basis” at death. When reviewing your client’s overall estate-planning objectives, be aware that unlike other highly appreciated securities the client may own, the NUA stock will not receive the increase to market value at death and may present a large capital gains tax to the beneficiary. A plan to liquidate out of the NUA stock may be necessary to prevent erosion due to the tax the beneficiary will pay.
If your retiree was an active trader within the qualified plan buying and selling the employer stock, the basis may be significantly affected. If the market value of the stock is close to the basis of the stock, the benefits of using the NUA approach will be minimal. Under these circumstances, most of the rollout would be taxed as ordinary income.
Advisors who understand the power of NUA will have an opportunity to educate their clients that a rollover into an IRA is not their only choice. Learn this technique, provide a benefit with which most advisors are unfamiliar and gain new business.
Gregory B. Gagne, ChFC, is the owner of Affinity Investment Group, LLC, past president of NAIFA-New Hampshire, and a member of MDRT. For more information, contact him at firstname.lastname@example.org.