In many large publicly traded companies, it’s common to reward employees with employer stock. Usually through a profit-sharing or ESOP plan, or at least by allowing employees to purchase stock themselves inside of their 401(k) plan. The disadvantage is when you withdraw money from a company plan, it is taxed as ordinary income. However, the IRS — if you can believe it — has two special rules to help: Net Unrealized Appreciation (NUA) and Net Unrealized Depreciation (NUD).
Given today’s stock market volatility, it’s the NUD rule that piques my interest right now.
First things first – understand the NUA rule
Net Unrealized Appreciation (NUA) is a clunky technical term but an important potential tax-savings opportunity for those with company stock in their employer plan. Under the NUA rule, only the cost basis of the shares is subject to tax (and potentially an early withdrawal penalty) at the time of the distribution. In simple terms, the cost basis is what a person pays for the stock. The net unrealized appreciation is the growth of the stock above the cost basis. When you leave the employer and want to take a withdrawal of company stock from the retirement plan, if you follow the NUA rules, there could be a substantial tax savings. Here’s how:
The NUA is not subject to ordinary income tax until the company stock is sold and will never be subject to an early withdrawal penalty. When the stock is sold, the NUA is subject to tax at capital gains rates — not ordinary income tax rates, which can be much higher, depending on your income and current tax rates. Additionally, the NUA is not subject to the 3.8% Medicare surtax on net investment income. The favorable tax treatment for the NUA portion of company stock distributions is what we call the NUA rule.
Why Net Unrealized Depreciation now?
A similar sounding name, but different strategy all together, is Net Unrealized Depreciation, or NUD. Participants holding company stock within a retirement plan that has decreased sharply in value may want to consider resetting the cost basis of that stock by selling the stock within the plan and repurchasing it shortly thereafter inside the plan. Unlike stock transactions outside of a retirement plan, the “wash sale” rule does not apply. We call this “stepping-down” the cost basis – provided you repurchase the stock at a lower price.
Why consider stepping-down the basis? A bigger gap between the cost basis — what you paid for the stock — and the potential growth from that point forward creates more opportunity to apply the NUA rule in the future. The NUD strategy is particularly important now given the stock market volatility we’ve …….