Retiring executives with company stock in qualified retirement accounts--such as 401 (k)s or employee stock ownership plans--will typically roll over the plan proceeds into a tax-favored individual retirement account (IRA), for no cost. However, before doing so, they may wish to explore making a net unrealized appreciation (NUA) election.
The NUA election allows you to withdraw stock from your retirement account and pay ordinary taxes on the cost basis only; then whenever you sell the position, the net unrealized appreciation between the cost basis and current sale price incurs favorable capital gains tax treatment.
How do you decide which is best? The decision boils down to whether the immediate tax benefit of the NUA election outweighs the longer-term benefit of growing diversified assets tax-deferred in an IRA. Although each individual case is different and future tax rates are unpredictable, three primary factors drive the analysis:
* Expected time horizon: The longer an executive's time horizon, the greater the likelihood that the tax-deferred growth of investing in an IRA will overcome the initial, onetime tax relief provided by the NUA election. For example, a 60-year-old who expects to live to at least 80 stands to benefit from the long-term growth of his assets in a tax-deferred IRA account, and therefore he might choose not to remove the equity and reduce his IRA assets through an NUA election. In contrast, a 70-year-old with similar life expectancy and a requirement to soon start withdrawing minimum distributions from his IRA might profit more from the onetime tax benefit of making an NUA election.
* Cost basis of retirement plan stock: The lower the cost basis of the stock, the greater the tax benefit of the NUA election. The immediate tax benefit from the NUA election can be viewed as a hurdle that the IRA strategy must overcome through years of tax-deferred growth. The lower the stock's cost basis, the higher the hurdle--and thus the longer the time horizon required for the IRA strategy to beat out the NUA election.
* Tax rate differential between ordinary income and capital gains: The greater the differential between the ordinary income and capital gains tax rates, the more attractive the NUA election becomes. For example, in the current tax rate environment, we assume a 15.8% differential for a typical executive, because the maximum federal tax rate is expected to return to 39.6% and the capital gains tax rate to 23.8% in 2013. However,...