Learn more about Kevin on NerdWallet’s Ask an Advisor
Many companies offer employees qualified plans to purchase company stock or they allow corporate contributions of company securities in other ways. Although it’s more common for larger, publicly-traded companies to provide stock-purchase plans, smaller, privately-held companies offer them, too. If you purchased company stock through such a plan, there’s good news: you have a tax mitigation tool available that may reduce your tax bill.
The IRS’ Publication 575 provides guidance to figure the tax on the taxable amount of a lump-sum distribution, which can be a better choice in some cases. A lump-sum distribution is an alternative to rolling a qualified plan balance into a new qualified corporate retirement plan or into an account like an IRA. A lump-sum distribution of employer securities — corporate stock, bonds or certain debentures — provides an option to defer the tax on the net unrealized appreciation (NUA) in the securities. NUA is the net increase in the securities’ value while they were in the qualified plan trust.
As an example, let’s say Harry has worked for publicly-traded company P for the past 20 years, and participated in the company’s employee stock purchase plan. During that time, Harry purchased $20,000 of P stock through salary deferrals to the plan. His plan balance is $80,000, which represents his $20,000, the basis, plus $60,000 of stock appreciation.
Harry is 65 and retiring and considering what to do with this plan balance. He can keep it in the company plan, but he will have to keep the investments concentrated in P stock, the only option available through the plan. Or, he can roll the stock, or the proceeds of selling the stock, into an IRA. Or, he can take a lump sum and take advantage of the NUA rules to reduce his tax burden.
If Harry takes a lump sum distribution of the P stock, then he will only be required to pay ordinary income tax on his $20,000. The appreciation of the stock, the NUA, which is $60,000, will be treated as long-term gains when Harry sells or exchanges the stock. Any growth beyond the basis and NUA will be taxable at capital gains rates depending on the holding period after distribution.
This means Harry would have to pay ordinary income tax on his $20,000 in the stock only when it’s distributed. If he holds the stock for a year or longer after the distribution date before selling the stock, the NUA amount and the additional gain beyond the NUA would be taxed at long-term capital gains rates instead of at ordinary income tax rates, which are higher. Since distributions from IRAs will be taxed at ordinary income tax rates, the NUA strategy can reduce tax bills over time.
If the company stock pays qualified dividends and Harry is in the 10% or 15% tax bracket during retirement, a 0% tax rate would apply to the dividends received. And even if Harry sells some of his stock each year and stays in the 10% or 15% bracket, then his long-term capital gains rate could be 0%. In some instances, the NUA strategy can generate significant tax savings over a 20- or 30-year retirement when compared with IRA distributions, which are taxed as ordinary income.
But it’s important to follow the rules to ensure that you can qualify for the tax advantages. Keep in mind that a lump-sum distribution that qualifies for NUA treatment is confined to a participant’s entire company security balance held in each kind of qualified plan (pension, profit-sharing or stock bonus plans) distributed in the same tax year, which is paid due to:
- The plan participant’s death
- The participant becomes totally or permanently disabled
- The plan participant reaches age 59.5
- The participant leaves the company
If the rules aren’t followed closely, then you could be exposed to more taxes than you anticipated, which can end up being less beneficial than the rollover option.
With that being said, qualified plans that include employer securities are eligible for NUA tax treatment, which provides another tool in your retirement planning toolbox. If implemented properly, NUA tax treatment can be helpful in minimizing taxes during retirement. Since the rules can be confusing, it’s wise to seek help from a tax professional who can help implement a compliant distribution process. If you have to bring it up as an option once you’ve told a broker or financial advisor about your situation instead of your advisor recognizing the potential benefit, then you probably need to find a new advisor.
If properly used, an NUA strategy applied to company stocks can help you achieve retirement security.