Do I need to know about NUAs?

0:00 Welcome to Something More with Chris Boyd. Chris Boyd is a Certified Financial Planner Practitioner and Senior Vice President and Financial Advisor at Wealth Enhancement Group, one of the nation's largest registered investment advisors. We call it Something More because we'd like to talk not only about those important dollar and cents issues, but also the quality of life issues that make the money matters matter. Here he is, your fulfillment facilitator, your partner in prosperity, advising clients on Cape Cod and across the country. Here's your host, Jay Christopher Boyd. Welcome to another episode of Something More with Chris Boyd. I'm Chris Boyd. I'm here with Jeff Perry, and we want to welcome our guest, Andy Ives.

0:43 He is from the Ed Slott & Company. He's one of the and company, I guess. Andy, you and your team do such a great job with the IRA help that you provide. Ed Slott, of course, is such a great wealth of information for so many years, but you all do such a great job and love having you as a guest. Thanks for being with us. Yeah, thank you. Happy to be here. I've been enjoying the program you guys put on for advisors. It's funny. You think you know a lot about this stuff.

1:24 Until you actually get into the weeds that you guys produce so much depth of content, I had no idea all that I didn't know, of course. But it's been a great education and I think it enhanced my professional skills. I really appreciate that. You want to talk about Ed Slott & Company and all that you guys do? Well, that's good to hear. I hear that from a lot of our member advisors. We've got about 500 members across the country. These are advisors that are looking to extend their educational knowledge base with IRAs and retirement plans. When we do our programs, anybody can come to a two-day program and basically they drink from a firehose.

2:10 We hammer them with as much information as possible and they come away saying exactly what you just said. I didn't know what I didn't know. So if they're looking to become a member, they're certainly welcome to do so. But yeah, keep an eye out for Ed Slott programs across the country. We do a couple a year and a virtual one each year. Even if you come to the two-day meeting, you'll walk away with a great manual and a ton of new information. That's so true. I just did a refresher on that because it did just so much content. I think I got more out of it the second time than I did the first. One of the things that you talked about was what we want to talk about today, and that was NUA.

2:55 I keep coming across this recently, just it had come up a few times. So maybe it was more on my radar after our going through this again recently, but it's the kind of thing I've been familiar with. I've run across over the years, but there's some details and nuances and things to be aware of. And I just thought this would be a really great episode for our listeners. And by the way, I'd be willing to bet whether you're a professional or a novice, you probably have seen Ed Slott on PBS or something like that. So you're familiar with the kind of expertise and information on IRA information we get.

3:36 So, Andy, let's talk about what is an NUA? Let's start with that. Yeah. Well, Net Unrealized Appreciation. So NUA stands for Net Unrealized Appreciation, and it is becoming more and more popular. I do present in our manual that I do present the NUA section. And I always ask when I go on stage, and there'll be like 350 advisors there from across the country. And I always ask who here has done an NUA transaction for a client. And over the years, more and more hands have gone up. So it is definitely becoming more and more prevalent. But basically what it is, it's a tax strategy that can help reduce the taxes paid on company stock and the appreciation of company stock that you might hold within your work plan, like a 401k.

4:30 So this is for, let's say a company, someone who's participated in a company plan and the employer says, and if you want, you can buy our stock basically. Right. And so they have not only money set aside for retirement, but specifically in their company stock. There, we talk about as advisors, oftentimes the, some of the hazards of that, you know, lived through the Enron era and all that kind of thing where people can have too many eggs in one basket with their income and their wealth. So it's always a good idea to keep a limit to how much, but in any event, let's assume you have this opportunity and you've had this commitment to kind of buy your company.

5:22 So now what are some triggering events that could sort of give someone this opportunity to, in essence, maybe you should, instead of the events, we should talk about what can you do? What's the virtue of this NUA process? How is it advantageous? Yeah, absolutely. And you're right. I agree with you on the whole concentrated securities thing. You know, we always preach diversification is key, but you know how real life works. A lot of people just plow as much money as they can into their 401k and they just buy their company stock or they buy the actual stock or they buy a stock fund. You can do this with a stock fund as well. But the way it works is this. I was a good, I was going to ask you about that. I'm glad you mentioned that.

6:03 Yeah. So that's one for sure. We can talk about that in a little more detail of how that works later on. But I like to explain it by saying, what would happen if you didn't do NUA? So let's say hypothetically a person has, they bought a million dollars of company stock in their 401k over their years of buying this company stock. And let's say that their cost basis, the amount that they paid for those shares over the years, the average cost basis was $200 ,000. And their appreciation over all those years is $800,000. If this person did not pursue NUA, they were never told about it. Their financial advisor didn't know about it. And they just went their business. They would probably at some point roll the 401k into an IRA after they retired, the million dollars in stock would go over to the IRA.

6:50 And then over time they would sell and withdraw it. And ultimately as they took that money out of the account or the IRA, they would pay ordinary income tax on the full $1 million. And they would be blind to any benefits that they might've had. Typical case, right? Typical case. If that person had had a knowledgeable financial advisor, like one of you guys, and that person was told about NUA, what they could have done was with the NUA strategy, paid long-term capital gains on the 800,000 and ordinary income on only the 200,000 of cost basis. So that is the NUA strategy in a nutshell, the tax benefit in a nutshell.

7:32 It's the spread between paying ordinary income on the $800,000 or long-term capital gains on the $800,000. That difference can lead to tens and even hundreds of thousands of dollars in tax savings. People probably understand this, but sometimes we think, oh, capital gains, that's unappealing. But in reality, what you just described is advantageous because capital gains are always less than income tax. So that's the desire. Now, one of the things that comes to my mind is what if I don't necessarily want to pay the tax on a million dollars or just $800,000, $200,000 at one time?

8:19 What if I only wanted to deal with some portion of it? Right, right. That's a good question. Yeah. So I went through basically the science of NUA, the math. This is the fixed numbers. But there is an art to applying NUA called the art of NUA. And that's identifying the tipping point where it makes sense for a client. I've had situations where we'll use the same numbers, where a person said, I can't afford the tax hit on a $200,000 distribution from my 401k. Is there any way we can massage that? You could do a partial NUA distribution. Let's say this person says, I can only afford the tax on $100,000 now.

9:01 You could take half of those shares and take half of those shares out of the account and only pay ordinary income on $100 ,000. And then you would have $400,000 of appreciation that you would, quote, unquote, that you would NUA. Now the other shares, the other half of those shares, if you roll those over to your IRA, you will never be able to do NUA on those shares. So that opportunity is lost. So this is only at the time of the transfer. That's right. So let me back up a little bit as far as if you wanted to do the NUA transaction, how does it work? This person that's got this million dollars in their 401k, they've probably got some other mutual funds in cash, et cetera. To qualify for an NUA distribution, the stocks, the company stock are transferred in kind out of that 401k into a regular non-qualified brokerage account.

9:51 That's the distribution from the plan. Everything else that remains in that plan, whether it's the half the shares or the funds or the cash or whatever, typically gets rolled over to an IRA. You have to empty the 401k. It's a lump sum distribution. You're basically cashing out of that 401k. Non-NUA stock goes to an IRA. NUA shares are transferred into a non-qualified brokerage account. That's your distribution. That triggers the taxable payout. And that's where you have the ordinary income due in the year of the distribution. So the year that you do this NUA transaction, you do have to pay the taxes on ordinary income on the cost basis.

10:31 The appreciation, that NUA, in this case, we're talking about the $800,000, that capital gains payment tax is not due until the shares are sold. You do not have to hold it for a year. So if you want to sell in a week, great. If you want to hold it for a couple of years, go for it. But you've locked in long-term capital gains on that appreciation. So that person who says, gee, I'm not sure I really can afford that. They have that option though. They could certainly sell some shares. They'd have some capital gains in the experience as well. But that may be part of that equation. Now, if they opted to do this, just in this hypothetical, someone said, oh, I'm going to take half of those shares or whatever. Can they come back next year and take the other half?

11:14 They would not. That's a good question. And this is where people get sideways sometimes. I talk about this lump sum distribution. When you want to pursue an NUA transaction, you've got to get it all done in one calendar year. So whatever shares I want to take, if I do them all, if I do half, those go to my non-qualified brokerage account. The rest of that account, the lump sum distribution has to go to my IRA or be paid out or whatever. It's got to come out of the 401k. If there's stuff left over in that account the following year, you can't leave shares there to NUA again the following year because that would disqualify the lump sum distribution requirement. So it would basically nullify your original NUA distribution. So good question.

11:55 You can't do the other half the following year. Don't try to get too cute. No, I will say, because I've seen this happen before, sometimes dividends will trickle into the account the next year, or maybe the company will make a profit share contribution earlier than next year. Those will not disqualify the lump sum distribution. Any contributions that go into the account for the previous year when you did your NUA distribution, don't worry about those. Those aren't going to ruin the lump sum distribution qualification. Right. So maybe now we could go talk about what are the occasions? When do I have this opportunity to start thinking about these kinds of opportunities? Yeah, that's important because not everybody can just raise their hand and say, I want to do NUA.

12:39 You have to hit what we call trigger events. And there's only four of them. One of them is age 59 and a half. 59 and a half, once you hit it, that's a trigger. I like to think of it as your light goes on. Your NUA light is on, you're now eligible. You don't have to jump right away. You don't have to do the NUA distribution in the year you turn 59 and a half. Just recognize that your light is now on and then it'll stay on for years until you activate it. And we'll talk about activating the light. But 59 and a half is one. Separation from service is another. Disability, only for the self-employed. And then death. So really the ones that we see are 59 and a half and separation from service.

13:23 And then if that person doesn't proceed with NUA on either one of those occasions, their beneficiaries would have the opportunity based on the death trigger. Yeah. Which none of us are hoping for that. Right. All right. So these are big occasions. And what could disrupt my, turn off my light, as you put it? So I may not say I'm going to take that stock or take a rollover or lump sum. Necessarily, I might be still working at 59 and a half. Maybe there's plenty of good income and I don't want that tax yet, as an example.

14:05 So you said that can stay on, that there's an opportunity to continue. I could do that at 62 now, perhaps, right? What could disrupt that? Yeah. And that's where, again, people don't realize that their actions have consequences. So if I'm working and I've got this million dollar stock in my 401k and I turn 59 and a half, my NUA light is on and it's going to stay on. And then a couple of years later, I haven't done anything with my account. I haven't made any changes to the account. Then a couple of years later- Make your additions, your money going in every week or whatever it is. Still participating like normal, getting my company match and making my salary deferrals. Maybe I reallocate a little bit with some of the mutual funds.

14:47 I'm not really doing anything egregious with my account. That's not allowed. That's not a problem. Yeah. It's all good to go. But if let's say now I'm 62, 63, my NUA light is still on because of my 59 and a half trigger. And I say, I need to take a couple of dollars out because I want to take the family on vacation. I'm still working. My 401k allows in-service distributions. I take $10,000 out. That transaction will, what I like to think of, makes my NUA light start to flash. I've activated it by doing this distribution. Now I do have to go now. I've got to do my NUA transaction in that calendar year when I activated that light.

15:32 If I don't- In that case of the withdrawal, like you described, a distribution, it's not necessarily that it has to sequentially be, oh, I take the stock distribution first. It just has to be done in that same calendar year, you're saying. That's right. That's right. So if your light is on and if you do it, take a distribution or where some people get sideways, even if you do an in-plan Roth conversion, it's basically when you generate a taxable event, a distribution, an in-plan conversion, that is what activates that NUA light. So if I take this distribution in January, February, March, I've got some time. I've got a few months here to get this NUA transaction done.

16:14 If I don't act on that, then at the end of the year, 1231, my NUA light, based on that 59.5 trigger, goes out. So if someone inadvertently, unaware of this NUA opportunity, happened to take an in-service withdrawal because they needed cash, is 59.5 the key there? If they did it at 58, it's okay. Didn't disqualify them. But if they did it after, unaware, after 59.5, it's not okay? That's a good question. Yeah. And that's accurate. Basically, the stuff you did prior to that trigger is not going to hurt you. So once you hit that trigger and the light comes on, now is when we're looking at your transactions.

16:59 And inadvertent is a good word because that's what we see a lot of times. People make inadvertent moves, not understanding the consequences, and they ruin their NUA opportunity. But it's not the end of the world. This person that turns 59.5 hits the trigger, and then does an in-plan conversion, isn't aware of what they do. They inadvertently activate it, and then they don't act on that light. Right. Three years later. Right. If they then separate from service a few years later, their trigger light goes back on. So NUA is going to be available at that point again. Just for clarity, for those who might not have heard that term separate from service, essentially, that's just retire, leave the employer, move to a different employer.

17:42 Just essentially, you're no longer an active participant in the plan, essentially, because you've left that employer for one reason or another. Accurate? Exactly. 100% accurate. And I've had that question. I had a person that worked at a company. They had good company stock. They separated from service. They left that company, and they left the 401k money there. They left the stock there, et cetera. They did take a job at another firm. So they weren't retired. They were still working, but they had separated from service from that original company. So they didn't lose the opportunity to do NUA because they took another job. They were separated from service. And also- Oh, sorry, go ahead.

18:23 No, I was going to say, when you do the NUA transaction, you can leave the money. Once you've left that company and your trigger light goes on, when you ultimately process your NUA distribution, if you were staying at that company, if you didn't leave the company, if you were acting on your 15 and a half trigger, if you do still work, because you can do this while you're still working, you cannot continue to participate in that plan. That's an important note. That's a big note. Yeah. It's a big note. So you said earlier about, I hit my 15 and a half trigger. I'm still putting money into the plan. I don't want to proceed with this yet. That is probably a wise move because like we just said, once you do NUA and you do the lump sum, you have basically cashed out and you cannot go back into that plan.

19:11 That's a great caveat to know. Yeah. That's a significant detail. So now this other situation, the gentleman or woman who moved to another company. So they've separated from service, the trigger light is on and they decide, well, instead of having the 401k here, the 401k there, maybe I'll roll this thing over. That's when they have to make this decision, right? About don't just bring all that money over and lose that opportunity. You can take advantage of pulling out the stock at its basis. Exactly. Because if that person that has left the company, if they proceed with a rollover and they roll all their 401k into an IRA, they have eliminated the opportunity to do NUA.

20:03 You can't move that company stock into the IRA and then do the NUA distribution. The stock must be transferred out in kind from the 401k directly to a non-qualified brokerage account. And then everything else can go to your IRA. Very good. And you mentioned stock funds can also participate in this program. Can you explain that? Yeah. So with a stock fund, when you leave your company, they will typically just convert that stock fund into actual shares. So they just take however much money you have in your stock fund divided by the share price, the current share price for the stock, and then they will go ahead and distribute those shares.

20:46 So yes, you can certainly do it with a stock fund when they convert that to shares. You can do it with private stock. You can do it from an ESOP plan. So there's a lot of flexibility as far as where that stock is coming from and the type of stock. Very good. So Andy, again, we're talking with Andy Ives of the Ed Slotin Company. What's the calculus that should go into this? How do I decide if it's a good idea or not? I would think, hey, capital gains is less than income tax. Shouldn't this be a no-brainer or is it more complicated than that? Well, again, that gets back to the art of NUA and it's identifying that tipping point.

21:30 We say that NUA doesn't make sense unless you have quote-unquote highly appreciated company stock. Well, highly appreciated to me might not mean highly appreciated to you. Any delta could make it worthwhile, but is it really worth going through all the activity you're saying? That's right. I've had people call and say they had a $25,000 cost basis and the value of the stock was $50,000. So 25,000 appreciation. When you do the math, capital gains on that versus ordinary income, maybe there'll be a couple of thousand dollars tax savings. Is it worth it to that person to proceed?

22:15 I've seen other ones where- A job even holder, so to speak. Exactly. Now, if this same person called and they had a $25,000 cost basis and the value of the stock was 500,000, that in my mind would make sense to pretty much anybody that you want to proceed with that. But again, identifying that tipping point where it makes sense. Interestingly, it couldn't even make sense if there was a penalty involved. And I'll give you an example. Let's say a person was only 50 years old and they had been working at a tech company or something that the stock has just rocketed it up. And I'll use the same example from the beginning when I said $200,000 basis and $800,000 of appreciation. They're 50 years old, they leave that company. So they've separated from service, trigger event, the light goes on.

23:01 That person could do NUA. If they did the NUA transaction, they're only 50. So it would be a distribution from their plan, they're under 59 and a half, there's going to be a 10% penalty. The 10% penalty only applies to the cost basis. So in that situation, there would be a penalty if they did a full distribution in the 200,000 of $20,000. But would that be worth it to get long-term capital gains on the $800,000 for ordinary income? So again, that's where you get into the art of NUA. Does it make sense? Does it make sense to pay the tax? How high an income they have and how...

23:42 Exactly. So there's definitely some mathematical equations that can be done, which you can ballpark it. You can say, all right, capital gains is this, ordinary income is this. And you can get an idea of what the tax savings would be. Yeah. Yeah, absolutely. All right. So that's the kind of thing that you're a good advisor will help you navigate as you go through this. What are some of the things we should be thinking about when we talk about NUA? What are the other considerations that people should be aware of? Well, there is... So a couple of things. I will say that... So if a person is eligible for NUA and they've got a good NUA opportunity and they proceed with the NUA distribution, so now they've got this company stock has been sent out of their 401k and is now in their non-qualified regular brokerage account.

24:27 As I said, they're going to pay ordinary income on the cost basis now. They will pay long-term capital gains on the NUA, that appreciation that occurred within the plan, long-term capital gains no matter when they sell it. If they hang on to those shares, there could certainly be additional appreciation after the money came out of the 401k. I call this an NUA parfait as far as the tax. You can picture the parfait with the layers. So the bottom layer is the ordinary income tax on the basis now. The second layer is long-term capital gains on the appreciation when you sell it. And then the third layer is any appreciation after distribution. That appreciation will also get long-term capital gains treatment, but it has to be held for a year.

25:12 So when you take it out of the plan, any additional appreciation is going to be long-term, but only if held for a year. A good problem to have. Yeah, a good one to have, for sure. It is a good problem to have. Don't wait the year you're dealing with income tax rates or short-term capital gains on the gains since the distribution you're saying. Exactly, that additional appreciation. So that's one thing to be aware of that impacts most people. There's an interesting nuance to NUA, which I've seen it a couple of times and it's a function of record keeping.

25:53 So there's something called specific identification method where I've been talking about examples of a $200 ,000 average cost basis, et cetera, $800,000 appreciation. If the plan or if the person, the participant keeps very good records, you can NUA specific shares. So if you're buying shares at the markets doing this over your career, you can NUA the low cost shares and not NUA the high cost shares. So if you have a record of when you bought these specific shares, you can pick and choose. Well, that brings me to one of the questions I was going to ask. What if it's the inverse?

26:34 Your million dollars has gone down in value. It's gone down $200,000 and it's worth $800,000. Would I even consider this? Well, you wouldn't consider it if you didn't have any appreciation, but I will say that you can reset your cost basis. And we've seen some whiplash in the markets here recently. If I have a decade before I'm going to retire, let's say, before I'm going to possibly hit a trigger and I've been buying company stock and now my company stock, my average cost basis is let's say $40 and the company stock was at $70, but now it has tanked for whatever reason.

27:15 And now the price per share is down to $30. I could sell everything and buy it back at $30. There's no wash sale rule within a 401k. So you can go ahead and reset your basis. Now you're going to have to spend some time waiting for that to come back up, but it is a way to take advantage of a market downturn. I actually just wrote an article about this just last couple of days, which will be in our next newsletter, talking about some opportunities. Could be an opportunity. Your timing's right and you want to hold the stock. We've seen a lot of volatility in the market recently. Is there any strategy that someone should be thinking about? That might be one example.

27:57 Yeah, certainly that resetting your cost basis is definitely one. The opposite can be true. We all know that when you've got these whiplash volatility in the market, some people lose sleep over that. You could have what is a very good annual opportunity after years and years of buying company stock, but then a person says, I just can't sleep with all this volatility and they sell their company stock. They sell it within the plan. They just eliminated the opportunity to do annual in the future. So panic selling certainly could be in the long run a bad, bad decision. Andy, this has been great. Love getting all this information.

28:39 Thank you. I think this is one of those topics that advisors are familiar with, but it's good to go over some of this and really understand how it works. And for consumers, they may not even be aware of it. So it's great to have the opportunity to share this along the way. So if you have a retirement plan where you've got company stock, pay attention, share this with others. If you've got others you know in your family or friends who might have, co-workers might have this kind of thing, share the podcast so they may benefit from it as well. Andy Ives, thanks for being with us as our guest.

29:20 Anything you want to plug for Ed Slott? When's the next opportunity? It sounds kind of complicated, but it's not really that terrible. As you just said, if you have a company slapping your plan, certainly be aware of it. And if you want to proceed with any way transaction, just call the plan. Say, listen, I want to do this. They'll typically have some paperwork for you to fill out. They know about it. They will walk you through the step. Let them hold your hand and you could save a ton of money in taxes. Until next time, everybody keeps striving for something more. Thank you for listening to Something More with Chris Boyd. Call us for help, whether it's for financial planning or portfolio management, insurance concerns, or those quality of life issues that make the money matters matter.

30:03 Whatever's on your mind, visit us at somethingmorewithchrisboyd .com or call us toll free at 866 -771-8901 or send us your questions to amr-info at wealthenhancement.com. You're listening to Something More with Chris Boyd, and I'll see you next time.