GRD Season 4 Episode 10-Is Net Unrealized Appreciation a Good Deal_mixdown
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[00:00:00] Hi, I'm Ed Slott. And I'm Jeff Levine. And we're two guys who just love to talk about retirement and taxes. Look, our mission is simple to educate you the saver, so that you can make better decisions because better decisions on the whole lead to better outcomes. And here's how we're going to do that. Each week, Jeff and I will debate the pros and the cons of a particular retirement strategy or topic with the goal of helping you keep more of your hard-earned money.

At the end of each debate, there's going to be one clear winner you. A more informed saver who can hopefully apply the merits of each side of the debate to your own personal situation. Decide what's best for you and your family. So here we go. Welcome to the Great Retirement Debate. Hey everyone, and welcome to the Great Retirement Debate.

I'm Jeff Levine. With me as always, is Ed Slott. Ed, good to see you again, my friend. Yeah, great to be here. Another good topic we haven't covered, I don't know if we've ever covered this one. All right, now, now, now, now you got me curious, what are we covering today? NUA Net [00:01:00] Unrealized Appreciation in employer securities.

Is it worth it? Now, before I, we get into that, we'll explain what it is, but this is one of those things that sometimes we explain at programs, and still today, this has been around. Just didn't develop over the last few years. And still the programs people don't even know it exists. A lot of consumers don't know it exists and advisors are shocked to learn about it, and they're also shocked.

We had one case with one of our, uh, elite advisors. That, uh, saved the client, I forget what the number two, $300,000 of actual tax money because he picked up, uh, this was Andy, picked up, uh, for one of our advisors that the NUA tax break applies at death to the inheritor. Uh, that, that's, you don't usually see that.

And, uh, they were gonna pay the fully, you know. And you, and I know you picked up when you were doing tax returns here. I know you had a client that you picked up and you saw they were selling stocks of the same [00:02:00] company you were doing their tax return. Do you remember that? And whatever. Yes, I do. Company was, remember that?

I remember that return. Yeah. That's weird how you could remember a single return from probably like 15 years ago, but yeah. Yeah. But you picked up and that was a key thing you picked up. You say, wait a minute, didn't you used to work for this company? And that's where it all evolved. So give us an overview of the NUA Tax break.

We call it Net Unrealized Appreciation in employer securities. Yep. And, and I would start by saying, sometimes you'll hear this and it makes me cringe a little bit, so sorry for those who do it, but sometimes people will call it New-Uh, which just drives me crazy. I don't like, but if I don't like it either, but yeah.

But if you've ever heard somebody say, New-Uh, this is probably what they're talking about. NUA. Yeah. Ah. I know. It's weird. I don't like it either. See, look. Look at it. Look at I, I, I hope our editors are keeping both of our faces up while we're saying that. It just, it is just weird. Yeah. Yeah. Like nails on a chalkboard.

Anyway, so what is this? Net unrealized depreciation. Well, ed, I have a question for you [00:03:00] in response to that ask, and that is, if I were to give you a choice of, would you like to pay taxes at ordinary income tax rates or at long-term capital gains rates, whenever you take money out of your retirement account, what would you tell me?

I thought you were going to get going to go a different way. Well, obviously the answer is the long-term capital gain rates, of course, because at no point is the long-term capital gain rate higher or stated differently At every income level. The long-term capital gain rate is significantly lower. Than the ordinary income tax bracket that you'd be in.

It varies. In some cases, for instance, if you are in the 22% tax bracket, you pay or you're at roughly a 15% long-term capital gain rate. So there's a seven percentage point difference. But if you're in a. 35% tax bracket, you might still also be in the 15% bracket for long-term capital gains, and you save 20%, it's like the rate is less than half.

So at all levels you can say long-term capital gains rates are better. [00:04:00] But in general, but that's another question. There's another question. Can you ever get, all right. Hit me with the other question. Can you ever get long-term capital gain rates out of an IRA? Well, the answer to that question is no. Uh, but the answer to a corollary question, can you ever get long-term capital gains out of a 401k Ah, good setup.

Yeah, so very nice. Nicely done. That was the AlleyOOP Ed, you, you kind of lof it nicely and I'll, I'll, I'll look to, to finish the play here. So don't we call that now, dropping dime. Dropping dimes. Oh, very good. Wow. Look at you. You, you are hip. You're a hipper than you look Ed, I gotta tell you. Oh boy. I'm gonna get in trouble for that one afterwards.

Okay, so we're back on with our NUA discussion. What is it? It's an opportunity to get. Long-term capital gains rates for what is usually a portion of your 401k distribution. It doesn't apply to everyone. What it applies to is gain on employer securities that accrue inside your plan. So [00:05:00] let's think about this.

Let's say you work for Company X and over the time you work for Company X, is that Twitter. Yeah, that's right. Company X now actually exists. How about that? You're right. You have to use a new company in the future. Yeah. Company Z. Yeah, company Z. We're gonna go with Company Z now, so it's So Company Z. You bought, let's say, over the years while you were working there.

$200,000 worth of Company Z stock inside your company, Z 401k plan. But over the years, company Z has done well and now what's worth $1 million? Well, Ed, we ask a a lot of questions of each other on this. I, I've got a really easy one for you here. If you started off with $200,000, that was the bout you purchased in the plan, in other words.

What would be your cost basis if it was purchased with non-retirement account money, but $200,000 was purchased and a million dollars is the current value. What is the difference between those two numbers? Ed, uh, hold on a second. Lucky my accountant. [00:06:00] You know. $800,000. Congratulations. We'll let you keep your CPA for another year.

That is correct. Ding ding, ding. All right, so $800,000. That is literally net unrealized depreciation. That is what NUA is. It's the appreciation on that stock. In our example, companies Z Stock that occurred. Inside your company, Z 401k, or other qualified plan, and if you make an NUA transaction, you do it, you follow certain rules, which Ed and I will talk about just in a moment.

Then when this distribution occurs, you'll pay ordinary income tax on the cost of those shares when you bought them. So our example was the $200,000 that becomes ordinary income right away and can boost your income higher. But the trade off of that is that the 800. Thousand dollars of gain will be taxed at long-term capital gains rates automatically whenever you sell those shares.

And that's true whether you sell them the next day [00:07:00] or whether you sell them years down the road so you can actually spread out your tax liability. And again. Long-term capital gains receive favorable treatment. So lemme stop you there. Trade off just to, sorry, go ahead, ed. Clarify. Verify that one point, that was an important point you made.

Even if you sell it the next day, normally to get long-term capital gain rates, you have to wait more than a year on a stock, not the case here. I try. You can do it the next day now for. For tax planning purposes, it often makes sense to spread out that liability and maybe sell some of that stock over time, but you have that luxury.

And again, the key difference here is that normally whenever that $800,000 came out of your retirement account, it would be taxed as ordinary income. The trade off is in exchange for paying ordinary income upfront on the cost. You get all the earnings at long-term capital gains rate. So naturally ed, the lower that cost or said differently, the greater the appreciation you have [00:08:00] on your employer stock.

The more NUA, the the more attractive the NUA tax break looks for you. And that, you know, I used to say when we were teaching this years ago, we used to use that same example and I would say that's an extreme example. 200,000. Now it's a million. You know, it's not so extreme anymore. Uh, a lot, not at all.

Just last week, ed, I looked at a scenario where the cost of. Where, where it was purchased over a number of years, uh, over two or three decades worth of work, and they had kept track of each of those purchases and the shares that were purchased early on. Over the first 10 or 15 years, the cost was about $125,000, and today the value of those shares some 30 years later is over $3 million.

So it was almost 30 x the uh, right of the cost. That's not a candidate, uh, that, that's a slam dunk. That one. Mm-hmm. So, obviously, you know, we said that this is [00:09:00] a special tax break, ed, we all know that the tax code is complicated. There are often if you want a certain D, you know, if you want a benefit, you've often gotta jump through a lot of hoops and there are rules and such.

So why don't you share with us what some of the rules for NUA net unrealized depreciation if you want. The capital gains treatment on those earnings, how do you get it? What are the rules that you have to follow? Well, first of all, you wanna see if you, if you want to even do it, and that's very subjective.

So there are some people with exactly the factors I would recommend, but the factors that you gave, 200,000 and a million, got all that appreciation. I would say that's a slam dunk too, to take it. You have to pay taxes on the 200,000 upfront on the cost. Some people say, I don't wanna do that. And this is one of those things where you take a lump sum distribution, that's the key.

It's a lump sum distribution. So right away people say, well, why would I take a lump sum at the, out my whole, uh, 401k? Because even the other assets have to come out. Uh, the non stock, [00:10:00] uh, you could, uh. You, you could roll over to an IRA. You could even mix and match and do some of the NUA stock to the IRA.

But let's say you, you wanna do the, the, the full NUA has to be qualify as a lump sum distribution has to occur in any one year. Any one year, but it has to follow what we call qualifying or triggering events. The most common one is separation from service. There's death, disability, and age 59 1/2.

But most commonly it's when you leave the company. Uh, but as I said early on. The death exception, you don't see much. But we caught one case like that where carried over to the beneficiary. And the general rule is if the deceased, say 401k employee that has the NUA stock would've qualified had he lived, so does the beneficiary.

Most people missed that. Or in the case I talked about where you picked it up on a tax return, I don't think the average accountant would've put two and two together and say. You may [00:11:00] have an NUA situation, so you have to have a lump sum, but it has to follow one of these triggering events. So we got a lump sum.

It follows the triggering event. Anything else? Well, and then the decision is totally subjective. Like I said, uh, you may be under 50 years old and then you could have a situation where you have a 10% penalty. Now, in another one of the podcast episodes we did, I mentioned this may be the one time because.

In general, I say the 10% penalty for an early distribution is a deal breaker for me to pay a penalty just to get to your money. This may be the exception to the rule. If you could get low basis that small, that lower amount, and there's high appreciation, like you talked about, get it out and it costs you 10% penalty.

In that case, it might just pay. So you're paying the ordinary income tax all in one shot plus. If you are under 55, and notice I said age 55 because, uh, the, it's the, that's the age in a [00:12:00] plan on separation from service. If you're separated from service at 55 or older, uh, at 55 or older, you don't have to wait till 59 1/2.

You can get out of the 10% penalty. So then it's really just a case of do, do you wanna pay tax on the cost? Do you wanna use the full NUA or part of it? But if you do the, if you qualify, you have the triggering event. The lump sum distribution has to occur all in one year, and it doesn't have to be the year after separation from service any one year, but you can have partial distributions in between.

It can get a little tricky. I wouldn't try this at home. I wouldn't try this without an advisor who is well versed in it. 'cause you could really mess this up. Agree. Then what happens is you pay the tax on the $200,000 and now. Uh, you move the NUA stock in kind. You don't sell it in the plan. That's another trap.

You move it as stock in kind to your [00:13:00] taxable brokerage account. The other plan assets move, say to an IRA generally. In other words, you're emptying out the plan. That's a lump sum distributions small. So if I were to. Summarize those three steps in order to get the tax treatment we talked about. Yeah. To get the capital gains treatment on the gain of those shares.

The three things you have to do are you have to take a lump sum distribution, so everything needs to come out of the plan. Both the stock and the non-stock stuff all in one calendar year that needs to happen after one of those triggering events, which would be death. Uh, hopefully not, but death would qualify, right?

Or age 59 1/2, or separation of service. Those would be the three triggering events that apply to NUA. And then the last thing is, whenever we do this, whenever we move everything out of the plan, in one calendar year, after one of those triggering events, the shares that we want to use, NUA, we want that tax break on.

We move them in kind as shares into a taxable account. [00:14:00] And then once you have it in the taxable account, it's no longer you paid the tax on the cost. You know the 200,000 in your example? Yeah. Anytime you sell those shares, and as you said, you could do it partially, uh, that automatically, even if you sell it the next day, you get.

Automatic long-term capital gain rates, which could be half as much as you would've eventually paid if you did an IRA rollover and pulled it all out of the IRA. And by the way, if you do the IRA rollover, you blow this deal completely. No backies, right? Like, as the kids say. Right? So, uh, so really the, the, the, the question that we started this episode with Ed, that you asked is, is the NUA tax break worth it, right?

Is it worth it? So let's think about what your, your trade off is on either side. On one hand, the the key benefit, if you will, of doing this, really the only benefit is that you're going to get long-term capital gains rates [00:15:00] on that appreciation. And of course, as we said, the greater the appreciation, the more that's beneficial because.

The less and less of the income that you have to pay ordinary income tax. On the flip side of this is that there are really two disadvantages when you do NUA. One is the cost of those shares. Whatever the purchase price, the cumulative purchase price is, you're going to have to pay ordinary income tax on whenever you do that.

So in our example, we said $200,000 grew to a million. Well. That 200,000 becomes ordinary income that could push you into a higher tax bracket now, et cetera. The other thing though, that you have to factor in is that if you do a rollover, if you ignore NUA tax treatment, all of the future growth and the interest, the dividends, the capital gains.

Continues to be tax deferred. Whereas if you do this NUA deal and then you sell your stock and let's say you wanna diversify into other investments, well, you no longer are in the tax deferred wrapper of a retirement account, right? You now are in a [00:16:00] regular taxable account. So you've lost that tax deferral element and that can factor in.

So, you know, let's think about this, ed, like, is the trade off worth it? I I, I think ultimately everyone knows our answer. Who's listened to any of our podcasts, right? The answer is. Yes, it's worth it. It depends, but lemme ask you something. Uh, but let's, I'm sorry, go ahead. Let's change the example. Let's, uh, reverse it.

Let's say the cost was 800,000 and the value was a million. Not worth. Alright, let's see if we disagree on this. Let's go ahead. Not worth it. Alright, so I'm gonna stop you there and I'm gonna say I disagree with you. You would pay tax on 800,000. Probably not. No, that's what I'm talking about. I way you didn't let me finish.

Oh, hold on. All right, so this is why I say like it depends. So one of the things you mentioned earlier, ed, is like you can do partial NUA, right? Oh, right, right. And what in, in many cases, ed, you said it earlier, what is the number one triggering point for NUA? What is the number one most [00:17:00] likely triggering event?

Well, separation from service. Separation from service, which means you are probably, you maybe retiring, right? Right. If you're re moving a new company though, so you don't know. But all right. Could be, could be moving to a new company, but let's just go with retirement. Right. All right. If it's retirement, you might need income in the near future.

Right. In your example, if you paid $800,000 for those investments and they grew to be worth a million, I agree it's probably not worth paying tax on $800,000 to get 200,000 out of long-term capital gains. Uh, very unlikely. Maybe if you're in the highest tax bracket, maybe you could make an argument there.

Uh, if you're gonna pay 37% no matter what, maybe get a little bit outta capital gain. But what about this? What if you're in a more modest tax bracket? You're going to need income right away. You're gonna need income for say, two years. And let's say you spend $75,000 a year. If you move all of that money over to an IRA and then you take a distribution from that IRA of [00:18:00] $75,000 a year.

What percentage of those IRA distributions are gonna be ordinary income ed? A hundred percent. A hundred percent right? Because we said everything that comes out of an IRA right, is going to be ordinary income. But what if instead? You did a partial NUA distribution for $150,000. 'cause that's the amount you're gonna keep in cash.

Oh, oh, okay. Because it's a near term expense right now, it's not maybe gonna be the thing that makes or breaks your life, but aren't you now getting out 20% of your 150,000 or $30,000 at lower rates? So, you know, to me, no, I was talking about doing the whole 800,000. Yes. Oh, I wouldn't, yeah, I wouldn't go that far.

Yeah, that's tough to make that work. Right? But you, but you know, partial NUA. But the point is, I don't want people to misunderstand what we're saying. Partial doesn't mean you still have to take it empty. That account, a lump sum distribution in one year. The 401k is still empty. The difference is instead of moving all of your stock over to the taxable account, some of your stock moved there [00:19:00] and some of it maybe you sold in the plan and moved over as cash in a rollover to an IRA.

That's what we mean by partial ua. Yep. Right. Now the other thing I think is worth going back is let's think about the bigger picture, the trade off of making this. If you're losing tax deferral, the question then becomes. How important is that tax deferral to you in your investment philosophy? Right. So let's say you're going to sell out of your company Z stock in our example, and you wanna be more diversified, but you decide that diversification is going to come in the form of buying an S&P 500 index fund that you just sit on forever until you die.

Well, there the fact that you don't have an IRA anymore. Who cares. You don't need the tax deferral because if you just hold an S&P 500 ETF, let's say, there's gonna be minimal dividends and you're gonna have nothing in the way of capital gains really to think about. And when you die, there'll be a step up in basis and all the tax liability will be wiped away.

Now, [00:20:00] if we go to the other extreme, you're gonna day trade, you know, investments. Well, that tax deferred wrapper really matters. So part of this evaluation of is NUA worth it? Well, we really need to add a little bit more. Is Nua worth it to you? And a lot of that is based on your tax brackets, your investment philosophy, and how tax efficient it will be and how valuable keeping that tax deferred wrapper could be for you in your particular situation.

I just wanna clarify one item you mentioned, step up in basis. I don't want people to get the idea. You get a step up in basis on NUA. You don't. You don't get a step up in basis on the part that's the NUA, but if you sell that and then reinvest it, then you would get the step up, right? But it still keeps its character long-term capital.

That's right. Yeah, that's true. Yep. Yeah. And actually now a lot of people, they miss that. And in fairness, if they miss it, you, you're, you, they're generally very happy that they missed it because they didn't real. But the other thing people [00:21:00] miss is high income individuals often pay the 3.8% surtax on NUA when they sell it, even though they're not supposed to.

Oh, right, right. 'cause no one tells the CPA, it was NUA. It's an exception to the 3.8% surtax rule. In fact you have to go, I've had this on returns. Uh, it's so annoying. I know what you're gonna say. You have to override the PA of the program. Yes. 'cause the every tax program, right. This is a big point here on the capital gains.

It's not the NUA, the capital gains that are attributable to NUA Net Unrealized Appreciation, newer, uh, are never, uh, are never subject to the 3.8% tax on net investment income, but. Nobody will tell you that. All you are going to see is a sale of stock on the brokerage account. You enter that capital gain into your tax program, it's going to push out the 3.8% tax.

You have to go into the tax program, override it and [00:22:00] say, not subject to the excluded from the 3.8%. I don't know of anybody really that's going to pick that up. No, it's gotta come from the, from from you directly as the person who owns that account, or in combination with your advisor who's helped you through this transaction and understands it.

But that has missed a lot, and that could create thousands and thousands of dollars. Of unnecessary taxes. You know, Ed, uh, I think it's one more thing it's worth pointing out. Like we're talking about this tax break and it's awesome for some individuals, but it's not just, you know, people who have this appreciation.

It's people who have this appreciation on their employer securities. And not every plan allows you to do that. And I think we both agree that. While it's an amazing tax break, at the end of the day, your first order of decision making should be what is the right investment mix for you. Because another way not to have high taxes is to lose all your money.

So if you don't think that having your employer stock is a great idea for an [00:23:00] investment point of view, who cares what the tax right is, right? Yeah. Remember, it is only a benefit on the appreciation. So if there's no appreciation, there's no tax benefit. Well, there is appreciation at the moment, but you, what you're saying is if you don't think the company has a bright future That's right.

That may be a consideration. That's right. Sometimes the, like the investment question is more important than the tax question. It's worth considering, but it's a second order type of factor of what is the tax treatment versus, you know, again, you can make no money and that would be another way to limit your tax liability.

Yeah, great. Uh, great advice and a final piece of advice here, and I, we said it earlier. Don't try this at home. This is something you need guidance from a, a well-educated advisor who understands these things. And that may be tough to find. Uh, you may be surprising them when you ask them about it. That's right.

A hundred percent. Well. We hope that you have an appreciation for the [00:24:00] complexities of nua after this discussion. It is a D, yes. New-Uh. Yeah, it's, I'm never, it's kind of like when people say, IRA, I just can't, it's an IRA, I know there's no ua. No Ira, IRA and NUA. At least when you're talking to Ed and I, that's, uh, that's what we can leave it at.

But we hope you appreciate the fact that this is a complicated area. Yeah, you do need advice and it's a trade off just like everything else. There are positives and negatives and the decision for each person should come down to. The specific facts and circumstances that apply to that person's individual situation, your individual situation.

So just like all of our debates here at the Great Retirement Debate, there's supposed to be one winner. You, the consumer, who can make a more informed and better educated decision as to what you should do for your future. And for your family. And so with that, we thank you for joining us for this episode of the Great Retirement Debate.

Ed, thanks for the insights as [00:25:00] always, and we'll see you real soon on the next episode of The Great Retirement Debate. Okay. Jeffrey Levine is Chief Planning Officer at Focus Partners. This podcast is for informational and educational purposes only, and should not be construed as specific investment accounting, legal or tax advice.

Certain information mentioned may be based on third party information, which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. The topic discussed and corresponding arguments are those of the speakers and may not accurately reflect those of focus partners.