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.

These factors have created a significant pool of clients who might benefit from an NUA strategy. Focusing your efforts on the following individuals should prove to be most beneficial:

Retiring corporate executives. Consulting with retiring executives about different NUA election strategies can guide them in making proper choices during the retirement distribution decision-making process.

Younger executives. Educating younger executives about NUA benefits can influence their qualified plan investment choices and prevent rollovers to other qualified plans or IRAs that would eliminate NUA election eligibility. In addition, informing these executives about NUA could allow them to benefit from the NUA election in the future.

Executives holding depressed stock. Counterintuitively, adding to qualified plan positions of depressed employer stock could magnify the tax benefits of NUA election, providing favorable long-term appreciation potential.

Human resource executives. Educating human resource executives about NUA benefits can build strong relationships, which may lead to highly qualified employee referrals.

On the other hand, the NUA strategy may not be appropriate for all investors. The following factors are critical:

Size of retirement account. Investors owning large amounts of employer stock are likely to benefit most. Consider the NUA strategy for clients who have long tenure or senior positions with their companies.

Time horizon. Investors not likely to retire or liquidate the stock for many years may benefit most. Consider how long shares may be left to appreciate.

Marginal tax benefit. Calculate potential taxes for both the NUA tax treatment and a direct rollover into an IRA. A client likely to retire into a lower tax bracket may pay less tax overall by simply rolling the stock into a new qualified account.

Diversification. A client overweighted in employer stock could consider the NUA strategy for a portion of the distribution. The balance could be rolled over into an IRA, where shares can be sold to purchase other investments. The potential tax savings may be lower, but the portfolio can be more diversified.

Risk tolerance. Because the NUA strategy may be most effective for stock held over the long term, consider whether the client is willing to keep the asset even if the price falls or stagnates for a time.

Estate plan. Explore whether the strategy might shift any undue tax burden to beneficiaries. Stock on which the NUA election has been exercised will become part of the client's taxable estate. Inherited NUA stock receives different income-tax treatment from other assets. There is no step-up in basis. NUA, like an IRA, is subject to income in respect of decedent. Heirs can still use capital gains rates for the embedded NUA when shares are sold, however, and appreciation in excess of the NUA gets a step-up in basis at the time of the individual's death.

For example, assume an client's 401(k) plan holds $1 million in employer stock at retirement. The cost basis of the stock is $200,000, and the NUA is $800,000. The individual takes a lump-sum distribution of the entire balance, pays tax on the cost basis of the stock, and does not sell any shares. At his or her death years later, the stock has a value of $2 million. The beneficiary then inherits the stock with a basis of $1.2 million ($2 million FMV minus $800,000 NUA).

If your client fits the profile for an NUA strategy, here are some considerations to keep in mind:

• The strategy is most commonly used with employer stock held in qualified plans (ESOPs, pensions, 401(k)s, etc.). Employer "stock funds" comprised of shares of stock and cash are also eligible as long as the plan provides for "in-kind" distribution of stock.
• The employee must elect a lump-sum, in-kind distribution from the plan (a complete distribution of all plan assets in a single calendar year). Distributions to employees under age 55 are subject to penalties at the time of distribution. Note that this applies to the original basis only, which provides an opportunity to effect premature distribution in a less punitive manner.
• Clients who have an immediate liquidity need (and have separated from service without taking any distributions) might use NUA with their employer securities to provide needed funds. Since only the basis is subject to the penalty and ordinary income taxes (with capital gains applied to NUA), total taxes on the distribution will likely be reduced.
• The NUA strategy can be used with a partial or a full distribution of employer stock. An individual can roll over some of the stock to an IRA and use the NUA strategy on the balance. Note that the NUA treatment is lost on shares rolled over to an IRA. Those whose qualified plan assets include mutual funds or cash in addition to company stock can choose an IRA rollover for those assets and use NUA on the stock.
• Unlike with conventional capital market transactions, there is no minimum holding period required for the NUA strategy to be beneficial. Therefore, for those seeking liquidity or diversification, NUA shares can be sold immediately upon election and will be taxed at the more favorable long-term capital gains rates.
• An automatic 20% of the tax due on the basis is immediately withheld. It's extremely important to notify the plan administrator about the NUA election to ensure withholding on only the cost-basis component and avoid withholding on the entire distribution.
• There is no rule regarding the time frame for electing NUA upon separation from service. Plan administrators determine corporate policy regarding distribution choices upon separation from service.
• Individuals may elect not to defer taxation on the NUA in employer securities distributed as part of a lump-sum distribution. To make this election, a client must attach a signed statement to that effect to the income-tax return filed for the year of the distribution and include the NUA as part of the distribution on Form 4972 (or on line 16 of Form 1040).
• Beneficiaries are eligible to elect NUA on the employer securities, provided they take a lump-sum distribution of the employee's balance.

Today, sophisticated solutions are required to help clients develop distribution strategies for their complex retirement needs. For clients with significant amounts of employer stock in their qualified retirement plan, consideration should be given to the NUA strategy.  FP

John A. Nersesian, CFP, CIMA, CIS, is managing director of Nuveen Investments Wealth Management Services Group in Chicago. He can be reached at john.nersesian@nuveen.com.