Net Unrealized Appreciation, usually referred to by its acronym NUA, is a complex and usually misunderstood area of tax planning when it comes to retirement plans that hold company stock within the plan. Here is an example, using Procter & Gamble’s plan, that will illustrate the use of NUA and its tax saving capability.
Let’s assume our subject, Linda, is getting ready to retire from P & G after a long career with the company. She has accumulated assets in both the 401k Savings Plan ($450,000) and the Profit Sharing Trust, or PST ($630,000). Inside Linda’s PST is P&G preferred stock, with a current value of $630,000 but a total cost basis of $70,000 (cost basis means the original purchase price of the stock inside the plan).
Correct execution of the NUA strategy consists of a couple of steps; in the first step, Linda will execute a rollover of her $450,000 401k Savings Plan into a traditional IRA. Since the 401k funds are all pre-tax assets, they will be taxed in retirement as she withdraws those funds. Linda may later work through tax-efficient withdrawals in retirement, or she may consider gradual conversion of these funds into a Roth IRA. In either case, she’ll have to pay income tax on these dollars at some point, and the distributions will be considered ordinary income.
The second step is where things get interesting, and where NUA comes into play. Linda elects to take a full distribution of the stock in the $630,000 PST. She will report the cost basis of the preferred shares, $70,000, as ordinary income in the year of the distribution. She will direct that the preferred shares themselves be distributed (they will be converted to P & G common stock upon distribution) into an individual brokerage account in Linda’s name. The end result, in our example, is that Linda will hold $630,000 worth of P&G common shares in her brokerage account, and those shares will have a cost basis of $70,000.
What is the tax effect? Linda has converted what normally would have been ordinary retirement income from the PST into capital gain income (other than the $70,000 she already paid tax on). Long term capital gains rates, for now, can be much lower than regular income tax rates. In some cases, the situation can be managed so that the federal tax paid on the gradual selling of the P&G common stock is zero.
For the purpose of this blog post, I have deliberately kept the example above very simple. The NUA strategy can be used with retirement plans where company stock is held inside the plan. Give our office a call if you want to discuss how the NUA strategy could work with your retirement plan.
Jared Walsh CFP®, CPA
Reservoir Wealth Management