Tax Tips

Simple tax planning can save you thousands of dollars

By Rick Paler

As investors reflect on tax season, many will ponder the large check they wrote to the IRS. They will then vow to never pay such a large amount again. That is great, but doing something about it is different. So now you might be wondering how you might cut your tax bill in future years.

Many advisors inform their client each year about the obvious. They might tell their clients to make a contribution to an individual retirement account commonly known as an IRA. They might even counsel their clients on participation in their employers sponsored retirement plan or to use losses to offset gains in their accounts. Unfortunately many tax professional miss a tax planning strategy that could save you thousands or even hundreds of thousands of dollars.

This potentially huge tax saver pops its head up usually only once or twice in someone’s entire working career. What is this magical tax saver? Is it a tax fraud scheme? Does it involve foreign countries that you never heard of or some guy in a back ally named Crusher? No, it is a legitimate planning tool that I would use at my wealth management firm for my clients.

This little known tax saver is called NUA or net unrealized appreciation. So now you might be asking, what is NUA and how can I use it to save on taxes? NUA is a terrific tax planning tool for individuals that have large positions of company stock in their retirement plans or stock bonus plans.

Individuals that are taking a distribution from their plan are able to take advantage of NUA, if they distribute the shares in kind from the plan and pay ordinary income taxes. Now you might be asking yourself how paying taxes saves you money. If I were to roll the distribution into an IRA, I would pay no taxes. This is correct, using NUA you would pay taxes now and if you rolled the distribution into an IRA account you would pay no taxes. You would only pay taxes when a distribution is made from the IRA account.

But let’s look deeper into both these scenarios. First let’s talk about NUA. Net unrealized appreciation is the difference between the current fair market value of the stock at the time of the distribution less the original tax basis for the shares of stock. When the stock is sold the appreciation will be taxed as long term capital gains. The current long term capital gains rate is 15%. Now remember that to take advantage of this you need to distribute the shares from a qualified plan. When taking the distribution you will be taxed on the value of the distribution at ordinary income tax rates.

The second option is rolling the distribution into an IRA account. By doing this you avoid paying any current taxes. The IRS will get their fair share, but at a later date. The IRS will tax you when you take distributions from your IRA and tax you at ordinary income tax rates which could be as high as 35%.

So what does all this really mean to you in terms of saving money on paying taxes? Let’s look at an example. Say you have 7,000 shares of employer stock in a qualified plan. Also assume that the company’s stock is trading at $80 per share making the value of the stock $560,000. You have worked at the company for a long time or you are lucky enough to work for a company whose stock is red hot. Because of this, your average cost basis for the shares are only $10 per share making your tax cost basis only $70,000.

Now you have decided to retire and take a full distribution of the shares from your retirement plan. Taking advantage of NUA, you will have to pay ordinary income tax on the cost basis of the shares. In this example we will say you are in the 28% tax bracket. Your tax bill on the distribution would be $19,600. Then when you sell the stock, even if it is the following day of the distribution, you will pay taxes at the long term capital gains rate of 15%. The value of the stock at the time of the distribution was $560,000 and your cost basis is only $70,000 making your long term capital gain $490,000. The tax bill for selling the shares will be $73,500. The total tax you will pay for taking advantage of net unrealized appreciation of the shares will be $93,100.

The other option you have is taking the distribution and rolling it into an individual retirement account or Rollover IRA. Now let’s say you take a full distribution from the IRA account. When you take the distribution you will be taxed at your ordinary income tax rate of 28%. The value of your IRA is $560,000, so your tax bill will be $156,800.

By taking advantage of net unrealized appreciation you will reduce your overall tax bill by $63,700 or 40%! I told you this has the potential to save you thousands of dollars.

You should also be aware that on top of the tax savings pointed out in this example, there are potential tax benefits for your estate. If you pass away and still own the stock your heirs will receive a step-up in the cost basis. The step-up in cost basis is from the time of the distribution until the date of death. Therefore, your heirs will not have to pay taxes on any of the appreciation. If you distribute the shares to an IRA and pass away your heirs will be taxed. Once the IRA is distributed to your heirs the distribution will be taxed as ordinary income, which means they might pay as much as 35% in taxes. But like all good things the government has strict requirements that must be met.

Let’s review some of these requirements. First the distribution must be made in a single tax year as a lump-sum distribution due to separation of service from your employer, reaching the age of 59 ½, death or retirement. The distribution also has to come from a qualified pension, profit-sharing or stock bonus plan. Note a spouse that is entitled to these assets due to a divorce settlement can also take advantage of this planning technique.

You must also have your cost basis for the company stock. If you do not have this information you should be able to obtain the information from your HR department or the plan provider. Also, make sure that when taking the distribution you inform your employer that you want the company stock distributed in kind. If they liquidate your shares and send you a check you will not be able to take advantage of NUA. Finally, if you decide to take the distribution as a rollover to your IRA and later determine that you would like to take advantage of NUA, it can not be done.

Employees that have large holdings of company stock with substantial gains should always consider both of these options before doing anything. I recommend that you contact your tax advisor prior to doing anything to discuss your options and to develop the best plan for your unique circumstances. This little secret called NUA has saved employees with large stock holdings millions over the years and might have the potential to save you money too.