REDUCING TAXES THROUGH EMPLOYER STOCK AND NET UNREALIZED APPRECIATION (NUA)

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1 Investors who hold employer stock (or other employer securities) as part of a qualified retirement plan may not know of the special tax rules that apply to any net unrealized appreciation (NUA) of their shares. As an important tax management tool, NUA should not be overlooked by those who want to manage their distributions effectively. The requirements to qualify for NUA special tax treatment are many and intricate. It is very important that investors consult with their tax advisors before executing this option. What is NUA? NUA is the increase in value of employer stock while held in a qualified retirement plan. The most common types of plans that include employer stock as an investment option are 401(k), profit sharing plans, stock bonus plans and employee stock ownership plans (ESOPs). The value of an investor s NUA is calculated at the time the employer stock is distributed from the plan as part of a lump-sum distribution. A lump-sum distribution is a payment from a qualified retirement plan of a participant s balance to the credit of the employee within one taxable year, due to an employee s death, attainment of age 59½, separation from service (except for the self-employed) or disability (applicable only to self-employed participants). Distributions taken from a plan in a prior year may prevent a subsequent distribution from qualifying as a lump-sum distribution to the participant. All similar plans of the employer are aggregated when determining a participant s balance to the credit for their lump-sum amount. If a distribution does not meet the lump-sum distribution requirements, only the NUA that is attributable to the participant s nondeductible employee contributions may be excluded from gross income for tax purposes. NUA is calculated by taking the trust s cost basis of the employer stock in the plan and subtracting that amount from the stock s fair market value at the time of distribution from the plan. The cost basis is determined by the trust based on the method it uses for the plan. The stock s current value is the amount the stockholder would receive if selling the shares on the date of the distribution. NUA applies to employer stock that is actually distributed. Rolling over some of the employer stock into an IRA (or other plan) does not defeat NUA treatment for the shares distributed. Rolling over non-nua assets into an IRA (or other plan) is quite common to avoid current year income recognition on the rest of the lump-sum distribution. Example Ellie, who is single, has participated in a 401(k) profit sharing plan through her employer, Big Time Corporation (BTC). A portion of her plan assets is invested in BTC common stock. At age 62, Ellie separates from service and requests a lump sum distribution, including shares of BTC stock. Value of BTC (employer) stock when the trust purchased it $150,000 Cost basis to the plan (same as the above) $150,000 Current value of BTC stock $350,000 Ellie s NUA ($350,000 $150,000) $200,000 Special tax treatment of NUA The special tax treatment granted to NUA falls under Section 402(e)(4) of the Internal Revenue Code. Under that section of the code, the NUA that is attributable to employer stock distributed to a participant from a qualified retirement plan as part or all of a lump-sum distribution may be excluded from the participant s gross income for tax purposes. Upon distribution, the participant pays ordinary income taxes (and the 10% penalty on premature withdrawals if applicable) on the cost basis of the shares not rolled over. NUA does not escape taxation completely. When distributed stock is eventually sold, any remaining NUA is considered long-term capital gain and taxed accordingly. However, this rate is typically lower than ordinary income tax rates. For example, the long-term capital gains rates for 2018 are 0%, 15% and 20%; the same as they were for (How the rates are applied in 2018 will be slightly different, however, because of the change to the federal income tax brackets as a result of the recent tax law change). In contrast, ordinary income brackets changed for 2018 as did the rates, which are 10%, 12%, 22%, 24%, 32%, 35% and 37%. Page 1 of 5

2 Thus, NUA may offer significant tax benefits, especially for investors who hold a sizable amount of employer stock in their plan and fall within the upper income tax brackets. Increases in the value of employer stock post-distribution are taxed at either the long- or short-term capital gains rate, depending on the length of time the stock is held outside the plan after the stock is distributed. Generally speaking, gains on shares held outside the plan for more than a year are taxed at the long-term capital gains rate. Post-distribution gains on shares held outside the plan for a year or less are short-term capital gains, which are taxed at the same rate as an individual s ordinary income tax rate. The holding period for the shares begins on the date following the date the shares are delivered to the transfer agent with instructions to reissue the stock in the employee s name long-term capital gains rate Single taxpayers Married filing jointly Head of household Married filing separately 0% Up to $38,600 Up to $77,200 Up to $51,700 Up to $38,600 15% $38,600 $425,800 $77,200 $479,000 $51,700 $452,400 $38,600 $239,500 20% Over $425,800 Over $479,000 Over $452,400 Over $239,500 Data source: P.L Please note, your employer stock can decline in value significantly between now and when you would ultimately sell the stock. The benefit of the NUA rules should be balanced against the risk that the stock will decline in value. The value of the stock may go down while inside the plan or after it s distributed. If the value of the stock decreases and is sold for less than the distribution value, only the remaining NUA (not the full NUA at the time of the distribution), if any, will be taxable. If, after it s distributed, the value of the stock decreases to an amount below the participant s cost basis in the stock, the participant avoids tax on the NUA and may be able to realize a loss (for the amount below basis) in the year the stock is sold. Regarding the 3.8% net investment income tax, NUA is not considered net investment income. However, any postdistribution gains will be considered net investment income and could be subject to the 3.8% tax. Tax considerations for beneficiaries If a plan participant dies after receiving a distribution of employer stock, the NUA is considered income in respect of a decedent. The plan participant s beneficiaries will pay longterm capital gains taxes on any NUA when they sell the shares; however, they will not be taxed on any increase in the value of the stock from the point of distribution until the date of death of the participant. In essence, they receive a step-up in basis in the stock for any gains accrued during that period. Any gain in the stock s value following the original owner s death, however, will be taxable to the beneficiaries as a long-term capital gain. Important concepts for preserving NUA Investors may lose the beneficial tax treatment associated with NUA if their employer stock is: Sold in the plan and the proceeds are paid out from the plan in cash Paid in a non-lump-sum distribution (in this case, only the NUA attributable to nondeductible employee contributions receives special tax treatment) Rolled over into an IRA (the special long-term capital gains tax rate does not apply to IRA distributions) In some plans, participants may self-direct the buying and selling of employer stock in their accounts. If available, this option should be exercised with caution. Investors can reduce their potential NUA significantly if they are frequently buying, selling and then repurchasing shares at a higher price. Such activity requires the plan participant to reset the cost basis each time, which could negatively affect the participant s NUA. NUA in action The following scenarios illustrate the tax ramifications of taking a lump-sum distribution that includes employer stock. Note that these assumptions are based on current tax law (as of January 2018). Future legislative changes could significantly alter the results illustrated. The 10% additional tax for early withdrawal may apply along with income taxes when withdrawing funds from a tax-deferred investment. Page 2 of 5

3 Scenario 1 Using the facts in the example on page 1, 62-year-old plan participant Ellie takes a lump-sum distribution of employer stock upon leaving her company. She will need to pay ordinary income taxes on the cost basis of $150,000 in the year of distribution. She will not be subject to an early withdrawal 10% additional tax because she was at least age 55 when she severed employment and took this distribution. Assuming because of Ellie s income, all of this income falls in the 35% tax bracket. Her federal income tax liability associated with the stock in the year it is distributed will be $52,500 ($150,000 of basis x 35%). She will not be taxed on the NUA portion ($200,000) until she sells the stock. Scenario 2 Three years after receiving her distribution, Ellie notes that the value of her shares has increased to $400,000. If Ellie decides to sell the shares, her NUA ($200,000) could be taxed at the long-term capital gains rate of 15%, or $30,000. The additional $50,000 increase in the stock s value also will be taxed at the long-term capital gains rate because of the length of time she held the stock outside the plan. The $50,000 of additional gain will result in a tax liability of $7,500 ($50,000 x 15%), for a total tax bill in year 3 of $37,500 ($30,000 + $7,500). Scenario 3 Assume the same facts as in the example on page 1, except that Ellie does not sell her stock. Instead she holds it outside the plan until her death, nine years after receiving the distribution valued at $350,000. At the time of her death, her shares are worth $600,000. Sam inherits the shares, with the following tax consequences Amount previously taxed (Ellie s cost basis) $150,000 Sam s additional basis for post-distribution gain ($600,000 $350,000) $250,000 Sam s new basis in stock $400,000 Original NUA $200,000 Sam s $400,000 basis in the inherited shares is Ellie s basis ($150,000), plus any appreciation between distribution and death ($250,000). When Sam decides to sell all of his inherited shares, $200,000 of gain is NUA taxed as long-term capital gain. Any additional gain on the stock from the point of Ellie s death until Sam sells the stock is also taxed as longterm capital gain, regardless of the length of time Sam holds the stock, due to a special rule for capital gain and loss on inherited property. If he sells all of the stock immediately, for $600,000, his $200,000 gain is all NUA, and assuming a longterm capital gains rate of 15%, his tax bill will be $30,000. Scenario 4 Assume the same facts as in the example on page 1, except this time Ellie does not sell the stock and three years later Ellie s employer declares bankruptcy. The value of Ellie s stock is now zero and she has already paid $52,500 in taxes (assuming a 35% tax bracket). A tax advisor can help her decide how to treat this stock. Hopefully, Ellie has other assets to fund her retirement years. This is why tax savings should always be a secondary consideration when developing a Company stock in defined contribution plans. The number of defined contribution plans offering employer stock as an investment option has hovered around 18% 19% over the past four years after a precipitous fall from 2008 to 2009 and gradual increase. The average allocation to employer stock has been averaging between 17% 18% since An estimated 32 million U.S. workers owned employer stock through workplace plans such as ESOPs, options, stock purchase plans and 401(k) plans. Of that total, 15 million owned employer stock through their employers defined contribution plans. 1 As the table below illustrates, a growing percentage (nearly 32%) of defined contribution plans that offer company stock as an investment limit the amount of plan assets that may be invested in company stock. The percentage of total plan dollars allocated to company stock in 2015 was 17.9%, representing a five-year high. 2 Year Percentage of plans that offer company stock Percentage of total plan dollars allocated to company stock Percentage of plans that limit the amount of plan assets in company stock Not available Source: Plan Sponsor Council of America, 59th Annual Survey, National Center for Employee Ownership, A Statistical Profile of Employee Ownership, November Profit Sharing Council of America, 59th Annual Plan Survey, Page 3 of 5

4 retirement investment strategy. Looking ahead Most plans that currently offer employer stock as an investment option are likely to continue doing so in the coming years, given the appeal to both plan sponsors and participants. That said, more plan sponsors are likely to educate their participants about the potential advantages of greater diversification. Although there are no regulatory limits to the amount of company stock any participant may hold, all plan sponsors have a fiduciary duty to manage their plans in the best interests of their participants. This includes, among other responsibilities, the obligation to select options that are appropriate for the plan and to monitor those investments on an ongoing basis to ensure they remain suitable for plan participants. If a plan offers company stock as an investment option or makes matching contributions with company stock, the employer must make an objective, prudent assessment as to whether the stock is an appropriate investment for the plan s participants. A portfolio concentrated in a single security is subject to sudden and dramatic losses. The potential effects on participants and their retirement security could be devastating should they over invest in the stock of a sponsoring employer. This is also true for individuals who decide to take advantage of the NUA strategy and continue to hold employer stock after terminating employment. Expanded diversification rules Provisions of the Pension Protection Act of 2006 require that employees be given an opportunity to diversify their retirement plan holdings away from company stock. As of 2007, all plan participants making voluntary salary deferrals, as well as those receiving employer-provided contributions (e.g., nonelective and matching contributions) who have at least three years of service, must be allowed to direct these amounts to alternative investments. In both cases, the alternative investments must consist of at least three investment options (other than employer stock) that are diversified and have materially different risk and return characteristics. Plan participants should consult with a financial advisor or their plan sponsor if they have questions about their investment options. Other options for stock distribution The decision of whether to pursue an NUA strategy as opposed to selling company stock in the plan or rolling over distributed shares into an IRA should be made only after careful consideration is given to an investor s financial circumstances and goals. While the potential tax benefits of an NUA strategy Pros and cons of various stock distribution strategies 3, 4 Options Pros Cons NUA strategy Generally, lower long-term capital gains tax rate applies For beneficiaries: NUA remains a long-term capital gain, and any market value gains between the time of distribution from the plan and the decedent s date of death are tax-free Can roll over the rest of the distribution into an IRA Generally, must take as part of a lump-sum distribution Ordinary income taxes due on cost basis when stock is distributed (potential 10% early withdrawal penalty) Investment risk of holding retirement assets in a single security both in the plan and after distribution Sale of stock in plan and distribution of proceeds Immediate liquidity Potential diversification of portfolio Lump-sum distribution not required Loss of NUA tax benefit Long-term capital gains tax rate not available (distributions taxed as ordinary income) Immediate tax liability upon distribution from plan IRA rollover 5 Employer stock remains tax-deferred Tax-deferred growth Potential diversification of portfolio Greater beneficiary options Stock held by the individual outside of an IRA or qualified retirement plan is not subject to the required minimum distribution rule Loss of NUA tax benefit Long-term capital gains tax rate not available (distributions taxed as ordinary income) No partial step-up in basis for beneficiaries 3 A 10% early withdrawal additional tax may apply to the cost basis if the lump-sum distribution occurs before age 59½ or if separated from service before age Consideration for the 10-year tax option available to plan participants born before January 2, 1936 is beyond the scope of this paper. 5 Whether a rollover is the right decision is a question that should only be answered after considering all available options (e.g., withdrawing the assets, leaving the assets in the plan or rolling them to an IRA or another employer s plan), taking into account such things as availability of investment options, fees and expenses, services, taxes and penalties, creditor protection, required minimum distributions and the tax treatment of employer stock. Page 4 of 5

5 are appealing, this solution is not appropriate for all investors. Consider, for instance, the tax treatment of any dividends earned on stock held outside a plan. In the case where the shares feature dividend payments, it may be more advantageous to roll the shares into an IRA to shelter that income stream from current taxation. That said, the tax rate on qualified dividends for 2018 align with the same income brackets that apply for the long-term capital gains tax rate, rather than the brackets for income tax. When considering a distribution of employer stock, many factors should be weighed, including: Does the participant feel strongly about owning the stock? What limitations, if any, does the plan impose? Does the participant understand the volatility of the stock and have other sufficient assets in the event the stock does poorly or becomes worthless? Is the participant under age 59½? If so, an early distribution 10% additional tax may apply. Does the participant have sufficient funds to pay the taxes due upon distribution? Does the benefit of tax deferral in an IRA outweigh the tax benefit of the NUA? What are the participant s legacy plans for any beneficiaries? When does the participant plan to sell the stock? Conclusion A great number of retirement plan participants hold employer stock as part of their investment portfolios. Yet many investors tend to overlook the potentially significant tax benefits associated with the NUA of their shares. Plan participants, especially those nearing retirement, should consider consulting with a financial advisor to determine if an NUA strategy is right for them. Some discussion questions may include: Do you have employer stock in your defined contribution plan? What is your employer stock concentration related to your overall retirement portfolio? What is the plan s cost basis in the stock? What is your NUA? What is your current tax bracket, and do you expect it to change? What are the tax ramifications of following an NUA strategy on some or all of the employer stock in the plan? When considering an NUA strategy, the first step is to determine whether holding employer stock is a good investment strategy for the particular investor. If it is, the next step is to perform an NUA analysis in partnership with a trusted advisor. By doing so, plan participants could help The views expressed are as of January 2018, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate. Investment products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC. This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Threadneedle Investments does not provide tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation. Material prepared by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Threadneedle Investments. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies. Columbia Management Investment Distributors, Inc., 225 Franklin Street, Boston, MA Columbia Management Investment Advisers, LLC. All rights reserved. CT-MK/ N (01/18) A4S8/ Page 5 of 5