Company-stock tax strategy poses opportunity and risk

CHICAGO — According to a recent report, there is ample opportunity for financial advisers to work with clients who own company stock using a little-known technique called net unrealized appreciation. The research, released last month by the Fidelity Research Institute, showed that this strategy is one of the most valuable but underused techniques that can save clients thousands of dollars. Yet few people understand it because of the complexity of the tax rules. And when the strategy is used, there often are mistakes, the analysis showed. “Research Insights Report: Maximizing the Value of Company Stock at Retirement” estimated that 24 billion people in the United States with a total of $400 billion in company stock assets could qualify to use the NUA strategy. “The employment of the federal tax rules for NUA is a benefit that is available to millions of Americans but that very few have ever heard of and which, properly utilized, can result in significant tax savings,” according to the report. NUA is the appreciation of company stocks purchased and held in a qualified plan above the initial purchase price — also called the cost basis. For example, if an employee purchases 100 shares of company stock for $20 a share, and five years later, the shares are worth $35 each, then the $3,500 current value consists of $2,000 of cost basis and $1,500 of NUA.
4 million participants The newly released paper scrutinized 4 million participants, ages 55 to 64, in the plans of Fidelity Investments. Advisers should educate clients about NUA, said the paper’s author, Steve Feinschreiber, senior vice president of the Fidelity Research Institute, a think tank funded by the Boston-based company. Although NUA isn’t the best strategy for all clients, individuals with company stock should at least investigate this option, he said. “One of those mistakes that individuals make is not talking to an adviser,” Mr. Feinschreiber said. “Most people aren’t taking advantage of the opportunity, because they don’t even know about it.” NUA allows clients to receive an in-kind distribution of the stock — that is, they get to keep the shares — and pay income tax on the average cost basis of the shares, rather than the current market value. When the shares eventually are sold, investors also have to pay tax on the net unrealized appreciation, but that amount maxes out at 15%. Subsequent gains following distribution would be subject to short- or long-term capital gains, depending on the holding period. Here is how NUA works: A client is about to retire and qualifies for a lump-sum distribution from a qualified retirement plan. Under the conventional strategy, rolling the distribution into an individual retirement account, the client pays up to 35% in ordinary income tax on the stock’s value, including any gains, upon withdrawal. By using the NUA strategy, the client receives the stock and pays ordinary income tax on the average cost basis, which represents the original cost of the shares. The strategy allows the client to continue to defer gains on all the earnings that accrue from when the stock is purchased until it is sold. At that point, the client is taxed on the appreciated value at the long-term capital gains rate, which is capped at 15%, provided they have held the stock at least 12 months after distribution. The problem with NUA is that it is complicated even for advisers, who often hesitate to complete this transaction, said Mark Cortazzo, a senior partner at MACRO Consulting Group LLC in Parsippany, N.J. “I think that the complexity behind it is a deterrent for people actually to execute it,” he said. Mr. Cortazzo also said that advisers can lose some of a client’s assets by recommending this strategy. “We see there are situations where advisers know about it but still don’t recommend it,” he said. “We’ve seen tremendous opportunities that are squandered because an adviser didn’t properly advise [clients about] them.”