For years, advisers have encouraged clients to accumulate retirement assets, in part by maximizing contributions to qualified retirement accounts. As retirement nears, these same clients will need help developing distribution strategies for those plan assets, and it's likely that employer stock will be a component of those assets. According to a 2004 survey of major employers by Hewitt Associates, 75% offer company stock as an option in 401(k) plans, and 65% of employees in those companies choose to own company stock, which accounts for 41% of the account balances of these employees.

When leaving the company, employees who own significant amounts of employer stock in a qualified plan--especially those who are younger--may benefit by treating the stock differently from other plan assets. Conventional wisdom may suggest leaving the stock in the plan or rolling it into an IRA. However, when the proceeds are liquidated in retirement, they are typically taxed as ordinary income, currently at rates of up to 45%--and possibly even more if state or local taxes apply.

Fortunately, there is an approach that can help save significant tax dollars on the distribution of retirement plan assets. The net unrealized appreciation (NUA) strategy provides a way to trade ordinary income taxation on a portion of retirement assets--appreciated employer stock--for long-term capital-gains treatment (plus any applicable state or local tax). Here's how this strategy works:

1. Upon separation of service, the investor elects a lump-sum, in-kind distribution of all employer stock from the qualified plan and moves at least a portion into a personal brokerage account.
2. The basis on the stock placed in the personal brokerage account will be immediately taxed as ordinary income, plus a 10% early withdrawal penalty if the investor is under age 55. (Qualified plan distributions made after separation from service after attaining age 55 are an exception to the general rule applying a 10% penalty on any pre-age-59^1/2 distributions).
3. When liquidated in retirement, the net value of these shares--the NUA--will be taxed as a long-term capital gain instead of ordinary income. Today, that's a rate of just 15%, compared to federal marginal income tax rates as high as 35%, plus any state or local tax.

To illustrate how an NUA strategy can reduce tax on employer stock, let's assume shares of employer securities, with a cost basis of $20, are distributed to an employee when the fair market value is $100 per share. Using the NUA strategy, the employee would pay tax at ordinary income-tax rates in the year of distribution on the $20 per share cost basis. Tax on the $80 per share appreciation is deferred until the shares are sold. At that point, the $80 per share appreciation will be taxed at long-term capital gains rates, even if they are sold the day after distribution. Any additional appreciation after distribution is taxed at short- or long-term rates depending on how long the shares are held.

Now let's consider the hypothetical case of a departing employee with employer stock in her qualified plan. In the first two scenarios in "When Rollovers Aren't Right" (see chart, below), we compare the results of rolling over employer stock into an IRA with taking a lump-sum distribution and using the NUA strategy. We assume that the current fair market value of her employee stock is $1.3 million.

If the employee rolls over her stock into an IRA, she will have $1.8 million (after taxes) in 10 years. If she chooses instead to take a lump-sum distribution of the stock and use the NUA strategy, she will have $2.3 million (after taxes) in 10 years. Thus, the incremental benefit of using the NUA strategy is about $503,000.

Next let's compare the benefits of NUA with an IRA rollover, assuming periodic distributions in both cases (see the chart's last two scenarios). Here, the fair market value of the employee stock at age 60 is $1.3 million, which grows to a pretax $2.8 million in the IRA rollover account and $2.3 million (after tax on basis) in the NUA account when the employee is 70^1/2. He then takes required minimum distributions from the IRA or matching distributions from the NUA account.

With the IRA rollover, the employee has a total after-tax benefit (income plus account value) of more than $5.8 million; with the NUA strategy, the total after-tax benefit is more than $8.1 million. In this case, the incremental benefit of using the NUA strategy is about $2.3 million.

Clearly, the benefits of using the NUA strategy can be substantial. Although the tax code has allowed NUA for over 60 years, a number of factors have combined recently to make it more viable:

• The permanent repeal in 2000 of the 15% excess retirement distribution tax on retirement plan distributions in excess of $160,000.
• The favorable equity market, which produced big gains in employer shares that could benefit from the lower taxation through the use of NUA.
• The greater gap between the ordinary income-tax rate (which applies to distributions from tax-deferred accounts) and the long-term capital gains rate, which applies to the gain on NUA shares due to the Tax Act of 2003.
• The increased popularity of defined contribution plans and the use of employer stock.