I recently received a call asking if they should take a net unrealized appreciation (NUA) distribution. I responded with everyone's favorite answer it depends. Tax Practice Corner - A 401(k) Tax Break That's Often No Break suggests that most advisers automatically tell their clients to take a NUA distribution and discusses the importance of running the numbers first. There are many factors to consider, including the impact of federal and state taxes, the 10% excise tax under IRC Section 72(t) - 10-percent additional tax on early distributions from qualified retirement plans, the rate of return of the ongoing investment(s), the investment(s) holding period, and required minimum distributions (RMDs). The article also provides a link to an interactive spreadsheet to help with the analysis:
You'll probably discover that the NUA approach works best only when the cost basis is very low or the investment horizon is relatively short. Otherwise
the client will have more money in the long term by transferring the stock to an IRA. With NUA, the funds grow at after-tax investment rates. In contrast, keeping the money in the IRA lets the entire amount grow until distributions start. And, while those distributions are fully taxable, the interim tax-deferred buildupat higher, pre-tax, investment ratescan be substantial.
Another NUA Perspective
Benefit Payment Government Filings/Net Unrealized Appreciation (NUA) discusses a 28-page report that evaluates the benefits of NUA, provides examples that consider tax rates, the absolute NUA, the ratio of NUA to the value of the stock, and the time horizon, and provides a model prepared to help evaluate the different choices:
The analysis reveals the following:
- For short holding periods, Choice #2 Electing NUA, distributing company stock to a taxable account, immediately selling the stock and reinvesting in a diversified equity portfolio provides the highest net after-tax liquidation value. Choice #2 should be strongly considered for holding periods of 10 years or less.
- For longer holding periods, Choice #3 Not electing NUA, rolling over company stock to an IRA, immediately selling the stock and reinvesting in a diversified 100% equity portfolio provides the highest net after-tax liquidation value. Choice #3 should be strongly considered for holding periods of 15 years or more.
- The higher the NUA as a percentage of market value, the greater the potential benefit from distributing company stock to a taxable account (Choice #2).
- The generally higher volatility of company stock reduces expected future values to such a degree that electing NUA and keeping the company stock in the taxable account, as in Choice #1, is never the best choice given the assumptions of the model. Under poor market conditions, Choice #1 significantly underperforms the other choices.
The post also discusses many other NUA issues, such as what is NUA, how does it work, and how to complete an IRS Form 1099-R for an NUA distribution.