By Andy Ives, CFP®, AIF®
Many company Retirement plans – like a 401(k) – offer company stock as an investment option. Under special tax rules, a plan participant can withdraw the stock and pay regular (ordinary) income tax on it, but only on the original cost and not on the market value, i.e., what the shares are worth on the date of the distribution. The difference (the appreciation) is called the net unrealized appreciation (NUA). NUA is the increase in the value of the employer stock from the time it was acquired to the date of the distribution to the plan participant.
The plan participant can elect to defer the tax on the NUA until he sells the stock. When he does sell, he will only pay tax at his current long-term capital gains rate – even if the stock is held for less than one year. To qualify for the tax deferral on NUA, the distribution must be a lump-sum distribution. This means the entire plan must be emptied in one calendar year, including all non-company stock within the plan. The distribution must also occur after any one of four triggering events: reaching age 59½; separation from service (not for self-employed); disability (only for the self-employed); or death.
At age 70 ½, a plan participant has hit the 59 ½ trigger event and may have also hit the separation from service event. Assuming one of these is still available and was not lost due to poor planning, NUA for the RMD is still alive. NUA stock can be used to satisfy a required minimum distribution (RMD), but the ordering and timing of the transactions are critical to success.
Typically, when an NUA transaction is done, all non-NUA stock and other assets are first rolled over to an IRA. Then the NUA shares are journaled to a “regular” (non-qualified) brokerage account. However, if an RMD is involved, this will create a problem. Why? RMDs can’t be rolled over. Here’s a workaround:
Step 1 – If a client needs to take an RMD, the first-dollars-out rule dictates that the first withdrawal counts toward the RMD. The first step would be to journal/transfer the appropriate amount of NUA shares out to a non-qualified brokerage account to cover the RMD. (RMDs are not subject to the 20% withholding rule because they cannot be rolled over, so this is of no concern.)
Step 2 – Next is a direct rollover/transfer of all non-NUA stock investments to an IRA. Any cash, mutual funds or other investments in the plan must be removed. As long as they are properly relocated to an IRA, the movement of non-NUA cash and investments will not be a taxable event.
Step 3 – With nothing left in the account except the NUA stock, and with no cash or other assets remaining to force a 20% withholding, the last of the NUA stock would be journaled to the regular non-qualified brokerage account. Be careful! Any NUA stock moved into an IRA will NOT qualify for the special tax break.
By following these steps, the RMD can be fully satisfied with NUA stock first, and the NUA lump sum distribution process can follow. Another benefit is that the full value of the NUA stock will count toward the RMD, not just the basis. (Just be sure these transactions are all done in one calendar year!)