I was speaking with a client this week. He told me that he recently retired and his financial advisor recommended he discuss a matter with me.
Me: So, what are we going to talk about?”
Chuck: I
worked for Costco for many years.”
Me: OK.”
Chuck: I
bought their stock all along.”
Me: Not sure where this is going. Are you diversifying?”
Chuck: Have
you heard of Net Unrealized Appreciation?”
Me: Sure have, but how does that apply to you?”
That was not my finest moment. I did not immediately
register that Chuck had – for many years – bought Costco stock inside
of his 401(k).
Take a look at this stock chart:
Costco stock was at $313 on February 7, 2020. Five years
later it is at $1,043.
It has appreciated – a lot.
I missed the boat on that one.
The appreciation is unrealized because Chuck has not
sold the stock.
The difference between the total value of the Costco stock
in his 401(k) and his cost in the stock (that is, the amount he paid over the
years buying Costco) is the net unrealized appreciation, abbreviated “NUA” and
commonly pronounced (NEW-AHH).
And Chuck has a tax option that I was not expecting.
His financial advisor did a good job of spotting it.
Let’s make up a few numbers as we talk about the opportunity
here.
Say Chuck has 800 shares. At a price of $1,043, the
stock is worth $834,400.
Say his average cost is 20 cents on the dollar:
$834,400 times 20% = cost of $166,880.
Chuck also owns stocks other than Costco in his
401(k). We will say those stocks are worth $165,600, bring the total value of
his 401(k) to an even $1 million.
Chuck retires. What is the likely thing he will do
with that 401(k)?
He will rollover the 401(k) to an IRA with Fidelity, T
Rowe, Vanguard, or someone like that.
He may wait or not, but eventually he will start
taking distributions from the IRA. If he delays long enough the government will
force him via required minimum distributions (RMDs).
How is the money taxed when distributed from the IRA?
It is taxed as ordinary income, meaning one can
potentially run through all the ordinary tax rates.
It was not that long ago (1980) that the maximum tax
rate was 70%. Granted, one would need a lot of income to climb through the rates
and get to 70%. But people did. Can you imagine the government forcing you to
take a distribution and then taking seventy cents on the dollar as its cut?
Hey, you say. What about those capital gains in the
401(k)? Is there no tax pop there?
Think of a 401(k) as Las Vegas. What happens in Las
Vegas stays in Las Vegas. What leaves Las Vegas is ordinary income.
And that gets us to net unrealized appreciation.
Congress saw the possible unfairness of someone owning stock in a regular, ordinary
taxable brokerage account rather than a tax-deferred retirement account. The
ordinary taxable account can have long-term capital gains. The retirement
account cannot.
Back to NEW-AHH.
How much is in that 401(k)?
A million dollars.
How much of that is Costco?
$834,400.
Let’s roll the Costco stock to a taxable brokerage
account. Let’s roll the balance ($165,600) to an IRA.
This would normally be financial suicide, as stock
going to a taxable account is considered a distribution. Distributions
from an IRA are ordinary income. How much is ordinary income tax on $834,400? I
can assure you it exceeds my ATM withdrawal limit.
Here is the NUA option:
You pay ordinary tax on your cost - not the value - in that Costco stock.
OK, that knocks it down to tax on $166,880.
It still a lot, but it is substantially less than the
general rule.
Does that mean you never pay tax on the appreciation –
the $667,520?
Please. Of course you will, eventually. But you now
have two potentially huge tax planning options.
First, hold the stock for at least a year and a day
and you will pay long-term capital gains (rather than ordinary income tax)
rates on the gain.
QUIZ: Let’s say that the above numbers stayed static for a year and a day. You then sold all the stock. How much is your gain? It is $667,520 (that is, $834,400 minus $166,880). You get credit (called “basis” in this context) for the income you previously reported.
What is the second option?
You control when you sell the stock. If you want to sell
a bit every year, you can delay paying taxes for years, maybe decades. Contrast
this with MRDs, where the government forces you to distribute money from the
account.
So why wouldn’t everybody go NUA?
Well, one reason is that (in our example) you pony up cash
equal to the tax on the $166,880. I suppose you could sell some of the Costco
stock to provide the cash, but that would create another gain triggering
another round of tax.
A second reason is your specific tax situation. If you
just leave it alone, distributions from a normal retirement account would be
taxable as ordinary income. If you NUA, you are paying tax now for the possibility
of paying reduced tax in the future. Take two people with differing incomes and
taxes and whatnot and you might arrive at two different answers.
Here are high-profile points to remember about net unrealized
appreciation:
(1) There must exist a retirement account at work.
(2) There must be company stock in that retirement
account.
(3) There is a qualified triggering event. The
likely one is that you retired.
(4) There must be a lump-sum distribution out of
that retirement account. At the end of the day, the retirement account must be empty.
(5) The stock part of the retirement account goes
one way (to a taxable account), and the balance goes another way (probably to
an IRA).
(6) The stock must be distributed in kind.
Selling the stock and rolling the cash will not work.
BTW taking advantage of NUA does not have to be all or
nothing. We used $834,400 as the value of the Costco stock in the above
example. You can NUA all of that – or just a portion. Let’s say that you want
to NUA $400,000 of the $834,400. Can you do that? Of course you can.
Chuck has a tax decision that I will never have.
Why is that?
CPA firms do not have traded stock.
