How to get a lower tax rate on employer stock in your retirement plan

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Under most circumstances, assets in company retirement plans are taxed at ordinary income rates when removed from the plan. One exception to that is employer stock acquired in the plan that elects Net Unrealized Appreciation treatment upon distribution. A lower long term capital gain rate can apply.

Q. Greetings Dan, Have a question re: [Net Unrealized Appreciation] NUA stock. I have a cost basis of about $230K worth about $260K. The taxes due if I take advantage of the NUA will be pretty big and I am not sure if the tax savings is worth coming up with the money to pay the tax liability today. Do you know if I can take half of the NUA and rollover the other half into an IRA? Thus, only facing half the tax liability today? Are you allowed to split it up? Thanks a million! Laura

A. Laura, you are smart to hesitate to elect Net Unrealized Appreciation (NUA) treatment.

The $230,000 basis would be taxable as ordinary income in the year distributed. That's tacked onto all the other income you may have during the year and the rate that would apply is likely high. If you are under 59½, you'll get hit with an early distribution penalty of an additional 10% to boot. In return, you can sell the shares and pay tax on the $30,000 gain ($260,000 less $230,000 basis) at long-term capital-gain rates.

If you roll the shares to an IRA, you are not taxed on the transfer or the sale of the stock, but are taxed at ordinary income when you take a distribution from the IRA.

There are, therefore, three tax rates to assess: the ordinary rate that applies to the basis of transferred NUA shares, the long term capital gain rate applied to the gain from the sale, and the ordinary rate that would apply when money is removed in the future from the IRA if the stock is rolled into an IRA to avoid all taxes today.

NUA works best when there is a significant difference between the capital-gains rate that would be paid on the sale of the stock and the rate on ordinary income tax when the money would be distributed. So, we are usually looking for a low basis compared to the value of the stock. Your description doesn't match that.

However, most people don't acquire company stock at one time. If you acquired your shares via a series of purchases, the shares acquired with each of your purchases carry their own basis. You can pick which lots to transfer and elect NUA treatment and which shares to transfer to an IRA.

If you have some low-basis shares, using those for NUA will reduce the taxes due on the transfer and maximize the gains that will be subject to the lower capital gains rate.

A good advisor can help you meet all the NUA requirements, crunch the numbers, and walk you through the scenarios that apply to you.

Dan Moisand's comments are for informational purposes only and are not a substitute for personalized advice. Consult your advisor about what is best for you. Some questions are edited for brevity.