Quick-quiz question: Is there ever a time when a client can pay capital gains tax rates on a distribution from a qualified retirement plan?
Answer: Yes, there is. This opportunity occurs when the client holds employer stock in the plan. The Net Unrealized Appreciation (NUA) in the stock can qualify for favorable long-term capital gains tax treatment, rather than ordinary income treatment, after a distribution is taken–but only if four IRS requirements are met:
- The distribution must occur at a triggering event, such as retirement or separation from service.
- The company stock must have been acquired with pre-tax employee contributions or employer matching contributions.
- The full vested balance in all employer plans must be distributed in a lump-sum–i.e., in the same tax year.
- The employer stock must be distributed to a non-retirement plan account. (Other plan assets can be transferred to an IRA.)
If all four requirements are met, income tax on the NUA will not be due until the stock is sold.
At the plan distribution event, the investor's cost basis in the stock is taxed as ordinary income.
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The remaining part of the stock's value, at the time of distribution from the plan, is NUA, and it is taxable when shares are sold as long-term capital gain. (The non-NUA portion is recovered at that time tax-free, because taxes have already been paid.)
Any further price gains in the stock, after distribution, also qualify for capital gains treatment, which will be long-term if the stock is held for more than one year after the distribution.
Having NUA can greatly increase planning flexibility in retirement. For example, in each year of retirement, a client can evaluate income needs and decide, with the help of a tax specialist, whether it is more advantageous to take ordinary income from qualified plans/IRAs or long-term capital gains by selling company stock.
Although clients must take required minimum distributions (RMDs) from IRAs each year after turning age 70½, no RMD are required from the company stock account.
Both the cost basis portion and the NUA portion can continue to enjoy tax-deferral indefinitely over the client's lifetime. At the owner's death, the beneficiary will inherit the NUA on the company stock (i.e., the long-term capital gain treatment will carry over to the beneficiary).
However, beneficiaries do not qualify for stepped-up basis on the stock at the owner's death, as they would if the stock were held in a regular non-plan brokerage account.
See this good explanation of the NUA concept, including a detailed tax example.
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