By Wesley Sebacher, CFP®, CAIA®
Investing in company stock through an employer-sponsored retirement plan can present individuals with an opportunity known as Net Unrealized Appreciation (NUA). NUA allows employees to take advantage of potentially significant tax benefits when distributing their employer’s stock from a qualified retirement plan. While this strategy can be advantageous in certain situations, it is important to consider both the benefits and drawbacks before making any decisions.
Benefits of Net Unrealized Appreciation
Tax Advantages: One of the primary benefits of utilizing NUA is the potential for significant tax savings. When employees take a distribution of employer stock from their retirement plan, they are only required to pay ordinary income tax on the cost basis of the stock, rather than the entire distribution. The appreciation, or the difference between the cost basis and the current market value, is subject to long-term capital gains tax rates when the stock is eventually sold. This can result in considerable tax savings, particularly if the stock has experienced substantial growth.
Example: Sarah has been working for ABC Corporation for many years, and during her tenure, she has accumulated a substantial amount of employer stock within her 401(k) plan. The cost basis of the stock is $50,000, but its current market value is $200,000. By utilizing NUA, Sarah can potentially pay ordinary income tax on the $50,000 cost basis, while deferring the capital gains tax on the $150,000 unrealized appreciation until she decides to sell the stock.
Diversification Opportunities: Another advantage of NUA is the flexibility it provides in terms of portfolio diversification. By distributing employer stock and holding it outside of the retirement plan, individuals can reallocate their investments and reduce their exposure to a single company’s stock. This can be particularly beneficial if the retirement plan’s equity allocation is mainly comprised of company stock. Diversification will reduce concentration risk and potentially increase stability of the portfolio.
Example: John has worked for XYZ Corporation for several years, and a significant portion of his retirement plan is invested in the company’s stock. By taking advantage of NUA, John can distribute the stock and transfer it to a taxable brokerage account. If he chooses to sell some of the company stock, the proceeds can be used to diversify his investments by allocating across a range of asset classes. The diversification will reduce his exposure to XYZ Corporation’s stock, and potentially lower his overall investment risk.
Drawbacks of Net Unrealized Appreciation
Loss of Tax-Deferred Growth: One drawback of utilizing NUA is the loss of potential tax-deferred growth on the distributed stock. When employer stock is held within a qualified retirement plan, any capital gains from the appreciation of the stock are tax-deferred until the time of distribution. By distributing the stock, individuals forgo this tax-deferred growth potential, which could have been significant over an extended period.
Example: Emily is considering taking advantage of NUA for the employer stock held in her retirement plan. However, she believes that the stock will continue to appreciate in the future. By choosing NUA, Emily would miss out on the opportunity for tax-deferred growth on the distributed stock if it continues to increase in value.
Concentration Risk: While NUA provides an opportunity for diversification, it is essential to consider the potential risks associated with holding a significant amount of employer stock outside of a retirement plan. By retaining a substantial portion of their retirement savings in a single stock, individuals may face increased concentration risk. If the value of the stock declines significantly, it can have a detrimental impact on their overall financial well-being.
Example: Michael has been working for LMN Corporation for many years, and a large portion of his retirement plan consists of the company’s stock. He decides to utilize NUA and holds the stock outside of the retirement plan. Unfortunately, the stock’s value declines sharply due to unforeseen circumstances, and Michael experiences a substantial loss in his retirement savings.
Conclusion
Net Unrealized Appreciation can provide individuals with significant tax advantages and the opportunity for portfolio diversification. However, it is crucial to carefully evaluate the benefits and drawbacks before making any decisions. While this article discusses some of the benefits and drawbacks, it is not a comprehensive list. The decision to utilize NUA should be based on individual circumstances, risk tolerance, and long-term financial goals. Additionally, benefits of this strategy are only available to those with an eligible retirement plan and meeting the requirements to qualify for NUA treatment. Consulting with a qualified financial professional can help individuals navigate the complexities of NUA and make informed choices to optimize their retirement savings strategy.
Have questions? Let’s Talk
© 2024 Advisory services offered by Moneta Group Investment Advisors, LLC, (“MGIA”) an investment adviser registered with the Securities and Exchange Commission (“SEC”). MGIA is a wholly owned subsidiary of Moneta Group, LLC. Registration as an investment adviser does not imply a certain level of skill or training. The information contained herein is for informational purposes only, is not intended to be comprehensive or exclusive, and is based on materials deemed reliable, but the accuracy of which has not been verified.
Trademarks and copyrights of materials referenced herein are the property of their respective owners. Index returns reflect total return, assuming reinvestment of dividends and interest. The returns do not reflect the effect of taxes and/or fees that an investor would incur. Examples contained herein are for illustrative purposes only based on generic assumptions. Given the dynamic nature of the subject matter and the environment in which this communication was written, the information contained herein is subject to change. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. An index is an unmanaged portfolio of specified securities and does not reflect any initial or ongoing expenses nor can it be invested in directly. Past performance is not indicative of future returns. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise.
