Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client owns employer stock in his pension account.  I have heard that he can get favorable tax treatment on the distribution of that stock.  How does that work?

Answer: A pension participant may be able to take advantage of the Net Unrealized Appreciation (NUA) rules.  When the plan trustee purchases employer stock for a participant’s account, the price paid becomes the cost basis.  At the time of distribution, a positive difference between the cost basis and fair market value is NUA.

For example, suppose employer stock is purchased for a participant’s account at a cost of $10 per share.  At the participant’s retirement, the stock has a fair market value of $50 per share.  The NUA is $40 per share.

If the participant takes a distribution of the employer stock as part of a complete qualified plan distribution and immediately sells the stock, it gets favorable tax treatment as follows: the cost basis ($10 per share in our example) is taxed as ordinary income, while the NUA ($40 per share in our example), is taxed as long-term capital gain.  For taxpayers in the highest tax bracket, paying at long-term capital gains rate can mean substantial tax savings.

If the participant liquidates the qualified account and holds the stock rather than selling, ordinary income tax must be paid on the cost basis in the year of distribution.  Upon a later sale, the participant will owe capital gains tax on the NUA.

If the participant rolled over the entire account balance to an IRA instead, 100% of any distributions to the IRA would be subject to ordinary income tax at the highest individual tax bracket.  Employer stock that is rolled over to an IRA loses favorable tax treatment and is treated as any other IRA investment. This is true even if the stock is rolled over as an in-kind distribution.  In essence, rolling over employer stock with NUA to an IRA converts capital gains into ordinary income.

Distributions from a qualified plan are subject to a 10% penalty unless on account of death, disability, attainment of age 59-1/2, or separation from service after attaining age 55.  The 10% penalty applies only to the ordinary income portion the distribution.

The favorable tax treatment of employer stock can be helpful in these circumstances.  Suppose, in our example, the participant has 1,000 shares of employer stock with a cost basis of $10 and fair market value of $50.  If the stock is taken as a LSD prior to age 55 and immediately sold, the participant would owe tax on the cost basis at, say, 35% plus a 10% penalty.  This would be 45% times $10,000 or $4,500.  The tax on the NUA would be 15% times $40,000 or $6,000, for a total tax of $10,500.  The 10% penalty does not apply to NUA.  Contrast this with a LSD of $50,000 cash where the tax would be 45% times $50,000, or $22,500.

When a client owns employer stock inside a 401(k) plan or an ESOP, it’s smart to pay attention to any NUA.  In many cases, it’s in the client’s income tax interest to leave the money in the 401(k) plan rather than transfer to an IRA.

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