Does the IRS Have a Gift for You?

BROOKFIELD, Wis., Nov. 13, 2012 /PRNewswire/ -- As 2012 comes to a close and the holidays are fast approaching, 'tis the season for giving. But I'll bet that never, in your wildest dreams, did you imagine that the IRS might be your "Secret Santa" this year!  Well, what they have to offer really isn't a secret – it is public knowledge available to any of us who look for it, and it has to do with company stock in your 401(k). If you work at a publicly traded company and participate in a 401(k) or other qualified retirement plan that allows you to invest in your employer's stock, I want to let you in on this "secret gift." Though it may sound more like the gift that is passed around the table at a White Elephant gift exchange, the topic of net unrealized appreciation is a simple and potentially beneficial opportunity with an unfortunately complex name.  And it could be your favorite gift this year.

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What is it?
When company stock, held in a qualified retirement plan, is distributed, the distribution includes two components: 1) the cost basis, which is the value of the stock when it was originally purchased, and 2) any gains or increase in value from the time of purchase to the time of distribution. In simple terms, NUA is the difference between the cost of the stock when you bought it in your plan (your basis) and the price for which you sell it after the distribution. For example, imagine you receive a distribution of company stock from your 401(k) plan upon retirement that is worth $300,000. The cost basis of the stock when it was purchased was $50,000. The $250,000 gain is the NUA. 

How Does it Work?
Upon retirement, a distribution from your company's retirement plan is typically taxable at ordinary income tax rates (the current maximum tax rate is 35%). To avoid immediate taxation, many people choose to rollover these assets to a traditional IRA.  While this may save taxes in the short term, the long term tax ramifications could be substantial if the employer stock plan is subject to ordinary income tax treatment (of up to 35%) on the part of the distribution that is classified as net unrealized appreciation (NUA). 

Utilizing the previous example where the NUA was $250,000, this NUA could be taxed at long term capital gains rates, which currently have a 15 percent maximum. In other words, the NUA is taxed at 15 percent rather than the ordinary income tax rate of 35 percent at a later date.

The 35 percent ordinary income tax rate is scheduled to increase in 2013 to 39.6 percent. The capital gains tax rate is set to go up to 25 percent. If you're over the age of 59½ years, or over 55 and retired, you should consider taking advantage of this now. 

In addition, the IRS allows you to take the distribution of the Net Unrealized Appreciation (NUA) portion of the stock and roll over the rest of the account. This means you would pay capital gains rates on the appreciation, but the rest of the assets would continue to grow tax deferred. This could be accomplished by taking a distribution of the NUA portion of company stock ($200,000 in the example above), and rolling over the remainder of the account to your IRA. You could sell the stock at that time (if you anticipate an increase in the tax rate) or hold it and sell it at a later date.

Can it Work For You?
Generally speaking, this strategy is most beneficial for individuals whose company stock has a relatively small cost basis and a large NUA.  However, to determine whether it's the best strategy for you depends on many variables and must be weighed against other investment options. Utilizing this "secret" strategy could yield significant tax savings. However, this information does not paint a complete picture of all available information necessary for making an investment decision. As you look at NUA and taxation strategies for your distributions, remember that each individual situation has unique nuances and complexities. Your age, the value of your full portfolio, anticipated tax rates, economic projections and your family's overall financial planning goals will all play into the right investment decision for you. 

It isn't very often that the IRS plays "Secret Santa," so take advantage of this opportunity and look now for an advisor to walk you through whether this investment option is right for you.  You need and deserve the honesty and integrity of a fee-only financial advisor who puts your needs first above their own. This should involve someone who will not only advise you on this issue, but will coordinate all aspects of your finances to ensure a strong and secure future for you and your family.  Don't be left with the White Elephant...claim your gift today!

Jim Cantrell, Certified Financial Planner and Registered Financial Advisor with the National Association of Personal Financial Advisors (NAPFA), is the owner and founder of Financial Strategies, Inc. (FSI), one of Wisconsin's leading Fee-Only wealth advisory firms. Jim is a Certified Financial Planner as well as a NAPFA Board Member with 23 years of experience in financial planning and investment advising.  Acting on behalf of clients, Jim and his team work hard to provide wealth management services to help clients achieve sustainable financial success.

SOURCE Financial Strategies, Inc.