If a taxpayer has employer stock in their employer-sponsored retirement plan, there is a special tax provision that allows a unique tax treatment for the portion of the distribution that represents the net unrealized appreciation (NUA) of the stock. The NUA rule is in §401(e)(4) of the Internal Revenue Code.

Let’s use an example to illustrate how this provision works.

Scott has an employer 401(k) plan with $250,000 of employer stock. The cost basis in those shares is $100,000. Scott leaves employment and wants to remove the stock from the employer's 401(k) plan.

If Scott does a lump-sum, in-kind distribution and takes possession of the employer stock, he can use the NUA strategy. He will only pay ordinary income tax on the stock’s cost basis, which is $100,000. The 10% early withdrawal penalty applies to the $100,000 amount if Scott is not over age 59.5 unless he meets another exception.

Let’s assume Scott holds the stock for six months outside the 401(k) plan and sells the entire amount for $260,000. Scott’s total gain on the stock sale is $160,000, which is its $260,000 fair market value less its $100,000 basis.

Of the $160,000 in gain, the $150,000 that represents the NUA is long-term capital gain, while the $10,000 appreciation is short-term capital gain since he held the stock outside of the 401(k) plan for one year or less. See Treas. Reg. §1.402(a)-1(b)(1)(i). These amounts may also be subject to the net investment income tax (NIIT) if the taxpayer’s adjusted gross income (AGI) exceeds the specified thresholds.

By using the NUA strategy, Scott:

1. Converts the NUA amount from ordinary income to capital gain,

2. Avoids the 10% early withdrawal penalty, if applicable, on the NUA amount, and

3. Receives dividends from the employer stock as qualified dividends subject to preferred capital gains rates.

If Scott transfers the employer stock by inheritance, the step-up in basis upon death under §1014 erases all deferred capital gains, and the heirs receive it tax-free.

If Scott rolls the employer stock into a traditional IRA, the NUA strategy is unavailable; however, Scott pays no income tax on the rollover amount. All future withdrawals of the rollover amount, and any income generated by those funds, will be ordinary income and subject to the 10% early withdrawal penalty unless Scott meets one of the penalty exceptions.

Scott will be required to take required minimum distributions (RMDs) from the IRA once he turns age 72. If Scott dies before the IRA is entirely distributed, the IRA beneficiaries will be required to distribute the funds as ordinary income, either gradually through life expectancy RMDs or quickly within ten years of Scott’s date of death.

There are, of course, downsides to the NUA strategy. To defer capital gain on the NUA amount, a taxpayer must retain the employer stock — it could be financially unwise for the taxpayer to have a large portion of net worth in one security. Within the IRA, a taxpayer could change the investment with no tax cost.

Another downside of the NUA strategy is that the taxpayer must come up with the cash to pay the tax on the cost basis amount without selling the stock.

A taxpayer who can potentially use the NUA strategy needs a tax planning engagement to determine if the strategy makes sense in their situation. As briefly discussed above, there are many factors to consider when making the NUA decision. The tax planner must take a holistic look at the taxpayer’s tax profile and overall retirement and estate plan to determine if the NUA strategy makes sense.

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California Wildfire Guidance Released

Commissioner Rettig sent a letter to Rep. Doug LaMalfa outlining the general tax treatment of Fire Victims Trust settlement payments to California wildfire victims.

Of course, it is very general; however, there are three primary considerations to reduce or defer tax for those who receive settlements.

Claimants may be eligible to exclude settlement amounts under §104(a)(2) if the damage award was made on account of personal physical injuries or illness. Punitive damages are not eligible for this exclusion.

Claimants may be eligible to exclude settlement amounts under §139(b) as a qualified disaster relief payment if the claimant’s area was within a federally-declared disaster area during the disaster declaration period. Eligible payments include those made for:

• Reasonable and necessary personal, family, living, or funeral expenses incurred as a result of the disaster, and

• Repair or rehabilitation of a personal residence or repair or replacement of its contents, to the extent that the need for such repair, rehabilitation, or replacement is attributable to the disaster.

If a claimant cannot use an income exclusion provision, they may be able to defer gain recognition under §1033 as the destruction of property by wildfire is an involuntary conversion. While an involuntary conversion of money is generally taxable, a claimant can elect to not recognize gain to the extent they purchase qualified replacement property within the required replacement period.

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Tom Talks Taxes Cocktail Hour

I’m excited to announce the first-ever Tom Talks Taxes cocktail hour at the Chandelier Bar at the Cosmopolitan in Las Vegas, NV.

If you are in Las Vegas for the NAEA Tax Summit or NATP Taxposium -- or simply want to come by -- I hope you'll join us.

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• Two-hour open bar and networking with colleagues

• One-hour online event co-hosted by Tom Gorczynski and Michelle Weinstein on August 5, 2022

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You must attend the event and check-in with the host to receive the above bonuses.

Tickets are $30 for Tom Talks Taxes free subscribers and tax professionals.

Tickets are $20 forTom Talks Taxes paid subscribers. See the June 30, 2022 edition for the promotional code.

Tickets are complimentary for Tom Talks Taxes Elite subscribers and Inner Circle with Tom members. Please get in touch with Tom directly for the promotional code.