Employee Stock Ownership Plans (ESOPs) are a great way to build retirement savings. Because the company contributes shares to a trust that holds them for the benefit of employees, there are no costs to participate, and the value of your shares can grow over time. While these plans are tax-deferred, the funds are taxed as ordinary income when they’re distributed (usually upon retirement or if you leave the company). However, if your ESOP allows for a distribution that qualifies as a Net Unrealized Appreciation (NUA) Distribution, you may be able to reduce your tax exposure. 

In this Insight, we’ll answer some of the questions you might have about how to use an NUA in combination with your ESOP.

What is an NUA?

When you hold company shares in a retirement plan that allows for an NUA distribution (check the plan document or with your ESOP trustee to confirm), you can roll them out of the retirement account and into a brokerage account when you have a “triggering event.”  

The catch: you must pay ordinary income tax on the basis amount of the shares that are rolled out of the plan. The benefit, though, is that all the appreciation that was in the retirement account and then rolled into the brokerage account is taxed at capital rates! 

What are the requirements for using an NUA?

First, you need to have appreciated company stock in a retirement account or expect the stock to appreciate. Second, you must have a triggering event, typically the attainment of age 59.5, or the separation of service from the company. Additionally, death and disability are considered triggering events for NUA. Third, the entire balance, lump sum, of the account must be distributed in the same calendar year. Finally, the company stock must be placed in a taxable brokerage account. 

Why would there be an issue with utilizing this strategy for company shares held in an ESOP?

Primarily, some Employee Stock Ownership Plans (ESOP) don’t allow the distribution of shares in kind. This means that ESOPs may require that the shares be liquidated or purchased back from the individuals by the ESOP trustee. If this condition is in the plan document, then a retiring employee will lose the potential benefit of the NUA strategy. This is a good time to check with the ESOP trustee or review your plan document to determine if an in-kind distribution is available.  If the shares are not able to be distributed in-kind from the ESOP, then this strategy is not available.

Does the NUA strategy make financial sense?

Before pursuing the NUA strategy, it is critical to assess whether it aligns with your overall financial and tax situation. This is a decision that should be reviewed in partnership with both your financial advisor and a tax professional. Like a Roth IRA conversion, the benefits of NUA depend heavily on timing and income levels. For example, if you distribute high-basis stock with minimal appreciation in a year when you are in a high-income tax bracket, you will pay ordinary income tax on the basis, which could outweigh any long-term tax advantages. On the other hand, if you execute the strategy in a lower-income year, such as after separating from service and before required minimum distributions (RMDs) begin, you may be able to realize more favorable tax treatment and maximize the value of the appreciation. 

What are the main pitfalls of NUA strategies? 

One of the most common mistakes with the NUA strategy is failing to complete the full lump sum distribution within a single calendar year. If you have a triggering event, let’s say you reach age 59.5, and decide to move some but not all company shares into a taxable brokerage account, the NUA opportunity is lost until a subsequent triggering event occurs. Suppose a triggering event is lost, and the shares remain in the retirement account until an RMD. In that case, you would owe ordinary income tax on the fair market value of the distributed shares rather than capital gains tax had the NUA strategy been utilized.

Should You Utilize the NUA Strategy?

Receiving company stock and holding it in a retirement plan can create an opportunity to take advantage of the NUA strategy. If one of your primary concerns is avoiding high taxes from RMDs, this can be an effective approach. However, it is essential to consider the tax bill in the year when the strategy is completed. Unlike some tax strategies that may be loosely interpreted, this one is clearly defined under IRS Code Section 402(e)(4).  

As a final point, work with your financial advisor and tax team to determine if this strategy works for you. Because these types of strategies are not one-size-fits-all, Cerity Partners advisors carefully consider them in light of your current portfolio and plans for the future.  

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