The net unrealized appreciation rule gives retirement-plan participants a considerable tax break when they sell off company stock, even if they are under age 59 1/2
We should all have such problems. In January, 2000, after a 17-year career with brokerage firm Charles Schwab (SCH
), Michelle Seymour had accumulated nearly $5 million in assets in her 401(k) and employee stock ownership plans (ESOPs). Although just 38 at the time, she decided to opt out of her job in a year. "I wanted to retire and enjoy the wealth I had built," says Seymour, who managed Schwab's Bakersfield (Calif.) branch office.
So what were her problems? Nearly 85% of her assets were in Schwab stock, and she clearly needed to diversify. Plus, she wanted to get her hands on a chunk of that money immediately without paying the taxes and early withdrawal penalties that could have eaten up 40% of her nest egg.
The answer to the first problem wasn't hard to fathom. At the beginning of last year, Seymour began selling chunks of Schwab stock each week and reinvesting the proceeds in stocks and mutual funds. Unfortunately, after going through a big run-up in the 1990s, Schwab shares were sinking along with the rest of the market. By the time she retired in January, 2001, her accounts were worth $3 million, and she rolled over $2 million of that into an individual retirement account.
DAMAGE CONTROL. The second problem--withdrawing the remaining $1 million without taking a huge tax and penalty hit--was trickier. After speaking with several longtime Schwab colleagues and consulting with attorneys and a financial planner, Seymour decided to use a little-known tax provision called the net unrealized appreciation rule (NUA). It allows retirement plan participants who receive distributions of their employer's stock to significantly limit their income-tax liability and early withdrawal penalty if the participant is under age 591/2.
The NUA rule works like this: When you leave your job, you take a distribution of the entire balance from one or more of your tax-deferred plans within one year. You invest the distributions in a taxable brokerage account in your name. You then pay ordinary income taxes only on the average cost basis of the stock, not the current market value on the day the assets are distributed. (The plan administrator can provide the average cost-basis information.)
The difference between the cost basis of the shares and their fair market value at the time of distribution from the plan is the net unrealized appreciation. Each time you sell some of the shares, you will pay taxes on any of the NUA, but then they will only be at the 20% long-term capital gains rate.
Look how this worked for Seymour (table): She put $1 million worth of her Schwab stock in a taxable account. The average cost basis was an astoundingly low 32 cents per share, or $30,000 in total. Therefore, Seymour paid ordinary income tax on only $30,000--estimated to be $10,800, since she was in the 36% tax bracket. Because she withdrew the shares before the age of 591/2, she owes an additional 10% early withdrawal penalty. But, like the taxes, the penalty is only on the average cost basis. "So what if you have a 10% penalty on $30,000?" says Christine Fahlund, senior financial planner with T. Rowe Price Advisory Service. "That's only $3,000." As Seymour sells the Schwab shares in her taxable account, she'll owe only 20% in capital gains taxes on the NUA.
Seymour still has $700,000 worth of Schwab shares left in her taxable account, or about 23% of her combined assets. "It's still more than I want, but I continue to sell a little bit every week," says Seymour, who admits she doesn't want to pay more capital gains taxes now, plus she thinks the stock will eventually rebound. In retrospect, she should have sold more sooner. Still, says Seymour, who is taking time off to be with her two children and rethink her career, "I feel confident about my retirement strategy because I educated myself about what I needed to know."
Corrections and Clarifications
"How to cash out of your company" (BusinessWeek Investor, Oct. 1) incorrectly stated that the net unrealized appreciation rule (NUA) requires individuals to take a distribution of their entire balance from tax-deferred plans within one year from when they leave their job. Individuals need not take distributions when they leave a company, but to qualify for NUA they must take all distributions within a year of taking the first one.
Copyright 2001 , by The McGraw-Hill Companies Inc. All rights reserved.
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