Net Unrealized Appreciation: The Untold Story

If you participate in a 401(k), employee stock ownership plan, or other qualified retirement plan that lets you invest in your employer’s stock, you need to know about net unrealized appreciation — a simple tax-deferral opportunity with an unfortunately complicated name.

When you receive a distribution from your employer’s retirement plan, the distribution is generally taxable to you at ordinary income tax rates. A common way of avoiding immediate taxation is to make a tax-free rollover to a traditional IRA. However, when you ultimately receive distributions from the IRA, they’ll also be taxed at ordinary income tax rates (special rules apply to Roth and other after-tax contributions that are generally tax-free when distributed).

But if your distribution includes employer stock (or other employer securities), you may have another option — you may be able to defer paying tax on the portion of your distribution that represents net unrealized appreciation (NUA). You won’t be taxed on the NUA until you sell the stock. What’s more, the NUA will be taxed at long-term capital gains rates — typically much lower than ordinary income tax rates. This strategy can often result in significant tax savings.

What is Net Unrealized Appreciation?

A distribution of employer stock consists of two parts: (1) the cost basis (that is, the value of the stock when it was contributed to, or purchased by, your plan) and (2) any increase in value over the cost basis until the date the stock is distributed to you. This increase in value over basis, fixed at the time the stock is distributed in-kind to you, is the NUA.

For example, assume you retire and receive a distribution of employer stock worth $500,000 from your 401(k) plan, and that the cost basis in the stock is $50,000. The $450,000 gain is NUA.

How Does it Work?

At the time you receive a lump-sum distribution that includes employer stock, you’ll pay ordinary income tax only on the cost basis in the employer securities. You won’t pay any tax on the NUA until you sell the securities. At that time the NUA is taxed at long-term capital gain rates, no matter how long you’ve held the securities outside of the plan (even if only for a single day). Any appreciation at the time of sale in excess of your NUA is taxed as either short-term or long-term capital gain, depending on how long you’ve held the stock outside the plan.

Using the example above, you would pay ordinary income tax on $50,000, the cost basis, when you receive your distribution (you may also be subject to a 10% early-distribution penalty if you’re not age 55 or totally disabled). Let’s say you sell the stock after 10 years, when it’s worth $750,000. At that time, you’ll pay long-term capital gains tax on your NUA ($450,000). You’ll also pay long-term capital gains tax on the additional appreciation ($250,000), since you held the stock for more than one year. Note that since you’ve already paid tax on the $50,000 cost basis, you won’t pay tax on that amount again when you sell the stock.

If your distribution includes cash in addition to the stock, you can either roll the cash over to an IRA or take it as a taxable distribution. And you don’t have to use the NUA strategy for all of your employer stock — you can roll a portion over to an IRA and apply NUA tax treatment to the rest.

What is a Lump-Sum Distribution?

In general, you’re allowed to use these favorable NUA tax rules only if you receive the employer securities as part of a lump-sum distribution. To qualify as a lump-sum distribution, both of the following conditions must be satisfied:

  • It must be a distribution of your entire balance, within a single tax year, from all of your employer’s qualified plans of the same type (that is, all pension plans, all profit-sharing plans, or all stock bonus plans); and
  • The distribution must be paid after you reach age 59½, or as a result of your separation from service, or after your death

There is one exception: Even if your distribution doesn’t qualify as a lump-sum distribution, any securities distributed from the plan that were purchased with your after-tax (non-Roth) contributions will be eligible for NUA tax treatment.

NUA Works for your Beneficiaries

If you die while you still hold employer securities in your retirement plan, your plan beneficiary can also use the NUA tax strategy if he or she receives a lump-sum distribution from the plan. The taxation is generally the same as if you had received the distribution (the stock doesn’t receive a step-up in basis, even though your beneficiary receives it as a result of your death).

If you’ve already received a distribution of employer stock, elected NUA tax treatment, and die before you sell the stock, your heir will have to pay long-term capital gains tax on the NUA when he or she sells the stock. However, any appreciation as of the date of your death in excess of NUA will forever escape taxation because, in this case, the stock will receive a step-up in basis. Using our example, if you die when your employer stock is worth $750,000, your heir will receive a step-up in basis for the $250,000 appreciation in excess of NUA at the time of your death. If your heir later sells the stock for $900,000, he or she will pay long-term capital gains tax on the $450,000 of NUA, as well as capital gains tax on any appreciation since your death ($150,000). The $250,000 of appreciation in excess of NUA as of your date of death will be tax-free.

Some Additional Considerations

  • If you want to take advantage of NUA treatment, make sure you don’t roll the stock over to an IRA. That will be irrevocable, and you’ll forever lose the NUA tax opportunity.
  • You can elect not to use the NUA option. In this case, the NUA will be subject to ordinary income tax (and a potential 10% early-distribution penalty) at the time you receive the distribution.
  • Stock held in an IRA, or an employer plan is entitled to significant protection from your creditors. You’ll lose that protection if you hold the stock in a taxable brokerage account.
  • Holding a significant amount of employer stock may not be appropriate for everyone. In some cases, it may make sense to diversify your investments.*
  • Be sure to consider the impact of any applicable state tax laws.

When is it the Best Choice?

In general, the NUA strategy makes the most sense for individuals who have a large amount of NUA and a relatively small cost basis. However, whether it’s right for you depends on many variables, including your age, estate planning goals, and anticipated tax rates. In some cases, rolling your distribution over to an IRA may be the better choice. And if you were born before 1936, other special tax rules might apply, making a taxable distribution your best option.

If you’re expecting a distribution of employer securities from a qualified retirement plan, make sure you speak with your financial professional at BFSG or tax professional before you take any action so that you can fully explore and understand all the options available to you. Only then can you be assured of making the decision that best meets your individual tax and non-tax goals.

*Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.

Prepared by Broadridge Advisor Solutions. Edited by BFSG. Copyright 2022.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

Tax-Free Investing with In-Plan Roth’s and Roth IRAs

By:  Crystal Kessler, CFP®, Wealth Advisor/Financial Planner

There is a lot of confusion when it comes to In-Plan Roth’s (i.e., Roth 401k or Roth 403b) and a Roth IRA. Throughout this article we will refer to just Roth 401ks but know the rules we refer to for Roth 401ks apply to other In-Plan Roth’s like 403bs. It is important to realize that these are two completely different investment vehicles, and they both have very different rules when it comes to eligibility and contributions.

First off, it helps to know the difference between Traditional vs. Roth. It mostly boils down to when you pay your taxes -now or later. With a Traditional Retirement Plan (i.e., 401k or 403b) or Traditional IRA (Individual Retirement Account), you make contributions with pre-tax dollars, and you get a tax break up front, thus helping to lower your current taxable income. Both contributions and earnings grow tax-deferred, meaning you do not pay taxes on it, until you withdraw it. With a Roth 401k or Roth IRA, it’s basically the reverse. You make your contributions with after-tax dollars, meaning there’s no upfront tax deduction and your income taxes are paid on that money before it goes into the account. Due to this, both the contributions and earnings grow tax free, and any withdrawals are tax free after you reach age 59 ½ (*withdrawals are tax free provided they are made at least 5 years after the first Roth contribution was made).

A Roth 401k is an employer sponsored retirement plan where an individual makes contributions directly from their paycheck to their company sponsored retirement account. Most employer plans give you the option to make your employee contributions to a Traditional 401k or a Roth 401k.

A Roth IRA is an account one can open at any investment firm and contribute to as long as they have earned income. However, there are income limitations to Roth IRAs when it comes to being able to contribute. To make a full contribution to a Roth IRA, as a single filer you must make less than $125,000 for 2021 ($129,000 for 2022). For married filing jointly, the combined income must be less than $198,000 for 2021 ($204,000 in 2022). The maximum contribution limit is $6,000 a year. However, there is a $1,000 catch-up contribution if you are over the age of 50. This allows an individual to contribute up to $7,000 if he or she is over the age of 50. If you are married and make less than the income limit, each spouse can make a full contribution to each of their Roth IRAs.

Example: If Jack (age 53) and Jill (age 54) file married, jointly and make less than $198,000 combined income in 2021 then Jack can contribute $7,000 to his Roth IRA and Jill can contribute $7,000 to her Roth IRA by April 18th, 2022, since they are both over age 50 and made less than the income limit set for 2021.

Most of the confusion with Roth 401k’s centers around if individuals can contribute to them because they see “Roth” and assume that if they make too much money then they can’t contribute to it. That is very wrong when it comes to Roth’s in retirement plans. Most employees are eligible for a Roth 401k and can contribute to it as long as their employer offers it in their retirement plan. A Roth 401k has no income limit whatsoever. The only limitation a Roth 401k has, is the plan’s contribution limit. For 2022 employees can contribute up to $20,500, and anyone over the age of 50 can make an additional catch-up contribution of $6,500. What is important to consider when contributing to a Roth 401k is the fact that you will be taxed on your income before you contribute to the Roth 401k, but the contributions and earnings grow tax free within the Roth 401k.

Example: Let’s look at Jack (age 53) and Jill (age 54) who file married, jointly and make $325,000 combined taxable income in 2022. Although they make too much to contribute to a Roth IRA, they can still contribute to a Roth 401k. Let’s say Jack maxes out his Roth 401k for the year, and because he is over age 50, he can make a maximum contribution, due to the catch up, of $27,000. He will be taxed on that $27,000 at their marginal tax bracket of 24%, but that full $27,000 will be contributed to the Roth 401k and grow tax free. Come retirement when Jack and Jill take distributions from the account it will all be income tax free. Another big difference between a Roth 401k and Roth IRA, is that Roth 401k accounts are subject to required minimum distributions. You are required to start taking tax-free withdrawals at age 72 from an Roth 401k. Roth IRA’s do not have this required minimum distribution requirement. However, you can rollover your Roth 401k account to a Roth IRA before age 72 and avoid the required minimum distributions.

Roth 401kRoth IRA
Income LimitationsNo Income limitationsSingle: Make less than $125,000 for 2021 ($129,000 for 2022).                                   
Married filing jointly: Combined income less than $198,000 for 2021 ($204,000 in 2022).
Contributions:$20,500 for 2022               
*Catch-up contribution if over age of 50 of $6,500
$6,000 2021 and 2022.

*Catch-up contribution if over age of 50 of $1,000
Contributions and EarningsGrows Tax-FreeGrows Tax-Free
Withdrawals after age 59.5*Income Tax FreeIncome Tax Free

* Withdrawals are tax free provided they are made at least 5 years after the first Roth contribution was made.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

What Retirement Plan Fiduciaries Need to Know About The Safe Harbor Relief for Lifetime Income Products Provided in the SECURE Act of 2019

By:  Tina Schackman, CFA®, Senior Retirement Plan Consultant

The SECURE Act of 2019 provided some much needed legislation to help improve coverage in retirement plans, incentives for small businesses, and additional safe harbors for retirement plan fiduciaries. One area that deserves a closer look is the newly created Section 404(e) of ERISA which provides safe harbor relief for the selection of lifetime income providers. The safe harbor provision under the SECURE Act of 2019 (the “Act”) for defined contribution plans states a fiduciary must undergo an “objective, thorough, and analytical search” to identify a provider for a lifetime income product, but it does not release fiduciaries from all of the risks associated with choosing an income product for their plan. The safe harbor provides relief for the selection of the provider, not the product.

Retirement plan providers offering these products typically only have their own proprietary product on their platform, so what is the likelihood the lifetime income provider or product selected is always going to be with the plan’s current provider? Until retirement plan providers are willing to offer non-proprietary lifetime income products on their platforms, retirement plan fiduciaries are going to be held to a standard of ensuring the product available with their current provider is suitable for their participants, but possibly not the most appropriate product.   

In order for retirement plan fiduciaries to fulfill the requirements under the safe harbor relief, there are two requirements that must be met when selecting a lifetime income provider:

1) Verify the Provider Can Meet Their Financial Obligations:  A thorough review of the financial capability of the provider must be completed to verify the provider is financially capable of satisfying its obligations under the retirement income contract.  This review must be done at the time of selection, and reviewed periodically (e.g., annually). Under the safe harbor, as long as the plan fiduciaries receive written representations from the provider verifying proper licensing, ability to meet state requirements, and undergo routine financial examinations, they can be assured they’ve met this requirement.

2) Reasonableness of Costs Analysis:  Fiduciaries must determine the costs (including fees and commissions) are reasonable for the guaranteed retirement income contract offered by the provider in relation to the benefit and product features (referred to as the “income guarantee fee”).   The Act goes on to state there is NO requirement for a fiduciary to select the least expensive option.    When conducting this type of analysis, it is important to note the income guarantee fee, withdrawal rates, and risk/volatility of the underlying portfolio are all interconnected.  For example, the income guarantee fee is partially based on the cost of hedging the risk of the underlying portfolio, such as a balanced fund.  But if your provider’s income solution only offers a very conservative portfolio option, then the income guarantee fee could be expected to be lower than other products with more aggressive portfolios.  Alternatively, if the withdrawal rates are lower than other products, it could be argued the income guarantee fee shouldn’t be as high as alternative products.   All three of these factors should be considered when reviewing the reasonableness of costs (See Illustration A). 

Illustration A

What about portability?

Portability of these products at the plan level and for participants has been an area of concern for fiduciaries because it could have an impact on terminating employees and how the assets would be administered in the event of a termination of a service provider.  The Act helps resolve the issue of plan level portability by creating a new “distributable event” that applies to lifetime income products when they are no longer allowed as an investment option within a plan.  In such situations, participants will be allowed to distribute their income product in-kind to an IRA rollover product beginning 90 days prior to the elimination of the product as an investment option.  If a plan sponsor wants to change retirement plan providers and is not able to transfer the lifetime income product to the new provider, all of the lifetime income assets will be rolled into the previous provider’s IRA rollover product. However, this may make the existing plan less desirable to the new provider, and the income product may be more expensive to maintain for those participants wanting to keep the lifetime income benefit.

As retirement plan fiduciaries continue to explore lifetime income products, many questions may arise around how the distribution phase works, how account balances can continue to grow, how participants can take all their money out of these products, etc.   From our experience, the real concerns behind lifetime income products surface when participants begin to execute on the guarantee and draw down the income benefit.   Reasonableness of fees and the ability of the provider to fulfill their financial obligations are critical elements of the due diligence process, but it should also be noted there are other areas of potential fiduciary liability that shouldn’t be overlooked and do not have protection under the Act. 

BFSG has the expertise to conduct a thorough analysis of lifetime income products, so please contact us if you are interested in a lifetime income product for your retirement plan or you have an existing product and are interested in learning how to obtain safe harbor relief. 

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

Use it or Lose it!

Year-end is fast approaching, and it is important to make sure that you are maximizing your employer benefits. Typically, many benefits reset at the end of each year, so here are some benefits to review before year-end to make sure you get the benefits you deserve.

1. Review Health and Dental benefits

If you have not done so, make appointments for annual checkups by year-end. For medical, this is good for a review of your overall health, especially as you age. For dental benefits, you often get things like two free cleanings per year, so make an appointment to at least get preventative measures done to reduce future costs. If you have an upcoming expensive dental procedure, you can start it now and use up the max benefit for 2020 and have the rest done in 2021 using the new benefits. This strategy can keep more money in your pocket!

2. Review your vacation time

Depending on the state you live in and/or your employers’ policy, some vacation time is not eligible for rollover, so make sure to not lose that time before year-end. If your employer allows you to roll overtime or get paid out, review your options now. Also, now is a great time to put in vacation requests for next year since many people delay doing this, and typically those that ask first are granted the time off first.

3. Use up your Medical Savings Account (MSA) by year-end

Your employer may offer a Health Savings Account or a Medical Savings Account. The Health Savings Account (HSA) can be rolled over so no need to spend the money, but the Medical Savings Account (MSA) must be spent by year-end or you lose the money you contributed!

4. Max out contributions to employer-sponsored retirement plans

If you are saving a lot towards retirement, review your contribution elections to see is you can max out your plan contributions for 2020 and plan for how much you will contribute in 2021.

As the new year approaches review your benefits to make sure you do not lose benefits you are entitled to before year-end. Now is also the ideal time to begin some planning for your benefits for 2021.

Happy National 401(k) Day

You started the week with Labor Day and get to end the week with Retirement – Happy National 401(k) Day! Now is the perfect time to make sure you’re taking full advantage of your employer’s sponsored retirement plan.

You can make pre-tax contributions to the retirement plan through payroll deductions. “Pre-tax” means that your contributions are deducted from your pay and contributed into your plan account before federal (and most state) income taxes are calculated. This reduces the amount of income tax you pay now. Moreover, you don’t pay income taxes on the amount you contribute — or any returns you earn on those contributions — until you withdraw your money from the plan.

Your retirement plan might also offer a Roth account. Contributions to a Roth account are made on an after-tax basis. Although there’s no up-front tax benefit when contributing to a Roth plan, withdrawals of earnings are free from federal income taxes as long as they are “qualified.” (Note: With Roth accounts, taxes apply to withdrawals of earnings only; withdrawals of contribution dollars are tax free.)

The decision of whether to contribute to a traditional plan, a Roth plan, or both depends on your personal situation. If you think you’ll be in a similar or higher tax bracket when you retire, you may find Roth contributions more appealing since qualified income from a Roth account is tax free. However, if you think you’ll be in a lower tax bracket in retirement, then contributing to a traditional pre-tax account may be more appropriate. A tax advisor can help you decide.

Employers are not required to contribute to employee accounts, but many do through what’s known as a matching contribution. Your employer can match your pre-tax contributions, your Roth contributions, or both. Most match programs are based on a certain formula — say, 50% of the first 6% of your salary that you contribute. If your plan offers an employer match, be sure to contribute enough to take maximum advantage of it. The match is a valuable benefit offered by your employer. In the example formula above, the employer is offering an additional 3% of your salary to invest for your future. Neglecting to contribute the required amount (and therefore not receiving the full match) is essentially turning down free money.

The IRS imposes combined limits on how much participants can contribute to their traditional and Roth savings plans each year. In 2020, that limit is $19,500. Participants age 50 and older can make additional “catch-up” contributions of $6,500 per year. [Special catch-up limits apply to certain participants in 403(b) and 457(b) plans.]

An employer-sponsored retirement savings plan offers a tax-advantaged opportunity to save for your future. Participating in your plan could be one of the smartest financial moves you make.