What are the Rules and Provisions of NUA?

The IRS rules governing the use of Net Unrealized Appreciation (NUA) are primarily outlined in the Internal Revenue Code (IRC) Section 402(e)(4) and Section 402(h)(1)(B). These rules provide the framework for the tax treatment of employer stock distributed from a retirement plan under the NUA strategy.

Historical Perspective

The history behind NUA treatment dates back to the Employee Retirement Income Security Act (ERISA) of 1974. This legislation was enacted to regulate employer-sponsored retirement plans and provide protections for employees. Under ERISA, employer stock held within a retirement plan became subject to special tax treatment.

The rationale for allowing NUA treatment is to provide a tax advantage to individuals who hold a significant amount of employer stock within their retirement plans. It recognizes that the appreciation in employer stock may represent a substantial portion of the account balance and could be subject to higher taxation if treated as ordinary income.

By allowing for the separate taxation of the NUA portion as long-term capital gains, individuals have the potential to benefit from lower tax rates. This treatment is seen as a way to encourage employee ownership and reward long-term investment in employer stock.

Key Rules and Provisions

1. Triggering Events: To be eligible, there are certain triggering events that need to occur. These triggering events include reaching the age of 59 1⁄2, separation from service (e.g., retirement, termination, or change of employment), disability, or death.

2. Lump-Sum Distribution: To utilize NUA, you must take an in-kind (meaning that you have to distribute the actual shares of company stock) lump-sum distribution of your entire retirement account balance, including employer stock held within the plan, in a single tax year.

3. Employer Stock Ownership: The employer stock must have been held within a qualified retirement plan, such as a 401(k) or an ESOP. It cannot be stock purchased outside of the retirement plan.

Bill’s Considerations

Bill is 57 and was just laid off from a company where he has worked for 28 years.  During this time he accumulated $300,000 of company stock, which cost him $40,000 to acquire.

The market value of the employer stock = $300,000

The cost basis of the employer stock = $40,000

The net unrealized appreciation = $260,000

In Bill’s situation, he meets all of the criteria to apply NUA treatment to his company stock.  His cost basis on the stock is relatively low, which implies there is likely meaningful economic value to taking the lump-sum distribution rather than rolling it over to an IRA.  

Bill meets the criteria to be able to take the lump- sum distribution, and while taking NUA appears to make economic sense, he is not yet 59 ½ years of age.  Would the 10% penalty for early withdrawals still apply?  It might. 

Rule of 55

  

The Rule of 55 allows individuals who separate from service from their employer in or after the year they turn 55 to take penalty-free withdrawals from their 401(k) plan. This means that if an individual meets the criteria of the Rule of 55, they can withdraw funds from their 401(k) plan without incurring the usual 10% early withdrawal penalty that typically applies to distributions taken before the age of 59½.

However, Bill is 57, and can use the “Rule of 55.” If he were younger than age 55, he would incur the 10% penalty on early withdrawals.  It’s important to understand the Rule of 55 is specific to penalty-free withdrawals from 401(k) plans and does not directly apply to the Net Unrealized Appreciation (NUA) tax treatment.

Wrapping it up

It's important to note that while NUA treatment can offer potential tax advantages, it may not be suitable for everyone. Factors such as investment risk, diversification, and individual tax circumstances should be carefully evaluated. 

There are important trade-offs when applying NUA treatment.  

Bill will be giving up all future tax deferral in exchange for paying ordinary income tax now for the cost basis of the shares and receiving preferential capital gains treatment for the remainder.  Additionally, if the stock is not sold prior to the owner's death, the shares of company stock will not receive a step-up in the basis upon the owner's death.  Consulting with a qualified tax professional or financial advisor is recommended to assess your specific situation and determine if NUA is appropriate for you.