Advisors and their clients are beginning to realize the advantages of distributing the net unrealized appreciation (NUA) built into shares of employer stock held in a retirement plan. The primary reason for making an NUA election is to convert the gain associated with this employer stock from taxable ordinary income to long-term capital gains. This result can be appealing to clients who have amassed a significant position in their employer's stock.

The NUA strategy is not the right fit for every client, however. Immediate income taxation and concentrated equity risk are issues that must be addressed by clients who elect to distribute NUA.

NUA Benefits 

The NUA strategy allows an employee holding employer stock within his or her retirement plan to distribute the entire plan balance in a lump sum and convert the gain associated with the employer stock from ordinary income to long-term capital gain. The employer stock must be distributed in kind to the client in certificate form (which can then be held in a taxable brokerage account), while the remainder of the plan balance can be rolled to an IRA for continued tax deferral.

NUA allows clients with highly appreciated employer stock in their retirement plans to take advantage of long-term capital gains rates (generally 15%) when the stock is ultimately sold outside of the plan. The favorable tax treatment associated with the NUA strategy is only available for lump-sum distributions resulting from one of the following actions:

• Plan participant turning 591/2;
• Plan participant separating from service (distribution penalties apply to those under age 55.);
• Plan participant becoming disabled; and
• Plan participant passing away.

The benefits of paying long-term capital gain taxes versus ordinary income taxes are obvious, but that doesn't mean the NUA strategy is without cost, of course. Distributing shares of employer stock creates an immediate ordinary income-tax liability. The client must pay tax on the basis of the distributed shares. This is determined by tallying the pretax employer and employee contributions associated with the purchase of the employer shares within the plan. Any appreciation above the basis is considered taxable long-term capital gain.

NUA in Action

An example may help clarify how the NUA strategy works. Through consistent pretax contributions, assume that John has been purchasing employer stock and mutual funds within his retirement plan for the past 20 years. During that time period, John has also been receiving matching contributions in the form of employer stock.

When John turns 60, he decides he is ready to retire. Rather than rolling the entire plan balance into an IRA, John's financial advisor suggests that he take advantage of the NUA strategy.

John's retirement plan balance consists of the following:

• $500,000 in mutual funds and money market funds and
• $1 million in employer stock ($200,000 of which consists of pretax contributions).

Using the NUA strategy, John will roll $500,000 in proceeds from his mutual funds and money market balances into an IRA. This move will ensure that those funds continue to grow tax-deferred.

The $1 million in employer stock will be distributed in kind to John. Because John is in the 35% tax bracket, he will owe $70,000 in income tax on the $200,000 of pretax contributions associated with the cost of the shares. That leaves $800,000 of NUA to be taxed as a long-term capital gain instead of ordinary income.

It's easy to recognize the advantage of NUA when a client has been accumulating employer stock within a retirement plan over his or her career. But once the shares are distributed, there are other issues that require attention.

Tax Effects 

The first issue is the out-of-pocket cost to the client. The client must be comfortable with the tax bill associated with the NUA strategy. Not only will the client owe ordinary income tax due to the distribution, but the client may also be propelled into a higher marginal tax bracket as well.

The second issue flows from the continued concentrated risk inherent in holding a large stake in one equity position. Diversifying a taxable portfolio involves the recognition of gains and losses. After paying a significant tax bill on the NUA distribution, clients may understandably not be terribly excited to hear about the capital gains taxes they will incur to reduce their risk through diversification.

Selling at least some of the shares outright may be the answer for some clients. Another option, however, is to explore a charitable remainder trust (CRT), which could be an excellent complement to the NUA strategy when incorporated into a client's financial plan.