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Attract and Retain Employees- Strive to be a "Best" Company Health Savings Accounts- A Win-Win Situation for Employer and Employees Net Unrealized Appreciation New Partners |
Summer 2005
Net Unrealized Appreciation
 Director Special rules apply when a retirement plan's lump-sum distribution (LSD) is composed in whole or in part of securities of the employer corporation. Under these rules, employees are not taxed on the net unrealized appreciation (NUA) when the securities are distributed directly to the participant. NUA is defined as the excess of the aggregate Fair Market Value (FMV) of the securities on the distribution date over the aggregate cost or other basis of such securities to the plan. If the securities are received directly by the participant, the NUA portion is not taxable. The amount that is included in income is the FMV of the securities less the NUA (normally, as ordinary income to the employee if not rolled-over and subject to the 10% penalty). When employer securities are sold after distribution, any gain realized is long-term capital gain to the extent attributable to NUA not taxed at the time of the LSD. Any gain in excess of NUA is long- or short-term capital gain depending on how long the taxpayer holds the securities after the LSD. Rolling over part of an LSD does not impact the favorable tax treatment allowed for the NUA of employer stock retained by the taxpayer. Thus, a taxpayer who receives an LSD consisting of both cash and appreciated employer stock can roll over all or part of the cash portion to an IRA and retain the appreciated employer stock outside of the IRA without affecting the favorable tax treatment allowed for the NUA in the stock. However, the FMV less the NUA would be subject to ordinary tax rates and potential 10% penalty for early distribution. If the securities are received directly by the participant, the Net Unrealized Appreciation portion is not taxable. Example: Sally leaves her job in 2002 and receives an LSD from her employer's 401(k) plan when she is age 50. The distribution consists of $200,000 of cash and $100,000 worth of employer stock. The original cost basis of the distributed stock is $10,000. Thus, there is $90,000 of NUA attributable to the stock ($100,000 - $10,000). If Sally rolls over the $200,000 of cash into an IRA and keeps the stock, she will pay income tax plus the 10% early distribution penalty tax on only the $10,000 of stock basis. She then can continue to defer tax on the $90,000 of NUA on the stock. The tax cost would be $10,000 times 35% plus $10,000 times 10% or $4,500. When Sally sells the stock, the $90,000 of gain will be taxed as long-term capital gains. The capital gains tax would be $90,000 times 15% or $13,500. Compare this to the tax at ordinary rates that could be as high as $90,000 times 35% or $31,500. Thus, by not rolling over appreciated stock into an IRA, Sally can save as much as $18,000 in tax for a cost of $4,500. Who won't sign up for that? Variation: Instead of keeping the stock, assume Sally rolls over the entire $300,000 LSD into an IRA in 2002. She will pay no income or early distribution penalty tax now, but will not be able to use the long-term capital gain tax rates on any subsequent distributions from the IRA. This is because the $90,000 of NUA loses its long-term capital gain status and is taxed at ordinary income tax rates when distributed from the IRA. Thus, by not rolling over the appreciated stock into an IRA, Sally pays a relatively small amount of income tax and penalty tax now in exchange for receiving favorable longterm capital gain treatment in the future. If you are eligible to receive an LSD from a plan consisting of appreciated employer stock, it probably makes sense to "run the numbers" and plan the distribution with a tax or financial planning specialist. |
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