By Andy Ives, CFP®, AIF®
IRA Analyst
For those workplace retirement plan participants fortunate enough to own highly appreciated company stock in their plan – like a 401(k) or ESOP – the net unrealized appreciation (NUA) strategy may be available. NUA allows a person receiving a workplace plan distribution to:
- Pay ordinary income tax on only the cost basis of company stock (the amount paid to acquire the stock in the plan) in the year of distribution.
- Pay tax at more favorable long-term capital gains (LTCG) rates on the appreciation when the stock is sold – even if sold within one year.
However, a person must hit a “trigger event” to be NUA eligible, and the plan must be completely emptied. Trigger events include turning age 59½, separation from service (not for the self-employed), disability (only for the self-employed), and death.
Example: Gonzo, a 401(k) participant at Muppet Company, owns ABC stock in his plan with a total value of $1 million and a cost basis of $200,000. If Gonzo did not pursue the NUA strategy, the entire $1 million would eventually be taxed at ordinary income rates. On the other hand, if Gonzo properly implemented the NUA strategy, then only the $200,000 cost basis would face ordinary income rates in the year he received the distribution from the plan. The $800,000 of appreciation that occurred within the plan would be taxed at LTCG rates when he sells the stock. The “spread” between paying higher ordinary income rates vs. LTCG rates on the $800,000 of appreciation is the NUA tax savings.
When it comes to determining a participant’s cost basis in company stock, plans will typically provide an average. Average cost basis is determined by dividing the total dollar amount used to purchase the shares (overall cost basis) by the current total value of the shares. That percentage is then multiplied by the current share price. From the example above, Gonzo’s overall cost basis is $200,000. Dividing that number by the current total value of his shares ($1 million) equals 20%. If the current share price of Muppet stock is $150, then Gonzo would have an average cost basis of $30 in each share ($150 x 20%).
But what if Gonzo (or the plan) maintained meticulous records and, over the years, was able to accurately document the actual purchase price of each share? As Muppet stock fluctuated, Gonzo may have bought shares early in his career at only $8 per share and bought shares more recently at over $100. Can Gonzo take an NUA distribution of only the low-basis shares of Muppet stock? Yes! NUA is not an all-or-nothing proposition. Partial NUA distributions are allowed. By distributing the low-basis shares in an NUA transaction and rolling the high-basis shares to his IRA, Gonzo can maximize his NUA opportunity. This targeting of low-basis shares is known as “specific identification,” but it is only available when detailed records of each purchase price are maintained.
If you have technical questions you would like to have answered, be sure to submit them to mailbag@irahelp.com, to be answered on an upcoming Slott Report Mailbag, published every Thursday.
https://irahelp.com/nua-average-cost-basis-vs-specific-identification/