For clients who have large holdings of their employers' stock in 401(k) plans, an attractive option for advisors has been to use the special tax break for net unrealized appreciation. Now, however, that option is no longer as clear-cut.
The break for net unrealized appreciation on lump-sum distributions from a qualified plan has allowed clients to trade ordinary income tax rates for long-term capital gains rates on a portion of their retirement savings, if they qualify under the lump-sum distribution provisions and have a triggering event: turning 591/2 years old, disability (only for the self-employed), separation from service (not for the self-employed) and death.
But the big tax package signed into law at the beginning of the year made changes to both ordinary income tax and long-term capital gains rates. In addition, a new 3.8% health care surtax on net investment income took effect at the start of 2013. Because this strategy is pegged to the disparity between tax rates for long-term capital gains and ordinary income, advisors must reevaluate the benefits of these transactions.
To use the net unrealized appreciation tax break, clients must have the appreciated securities (usually stock) of their employer inside a qualified plan. After the triggering event, the client must take a lump-sum distribution, emptying all like plans in one calendar year and moving the securities to a taxable account. If done properly, ordinary income tax is owed in the year of the transaction on the original cost of the shares, and then long-term capital gains are owed on the remaining appreciation when those shares are sold later on.
The appreciation is taxed at long-term capital gains rates regardless of when the stock is sold. This is true even if the client dies and a beneficiary does the selling; the net unrealized appreciation does not receive a step-up in basis at death.
For clients in the highest bracket, this strategy is now slightly less beneficial than it has been for the past several years, but it will in many cases still prove to be useful. In 2012, if clients in the highest ordinary income bracket had taken advantage of net unrealized appreciation, they would have effectively traded ordinary income tax of 35% to get long-term capital gains tax of 15% on a portion of their retirement funds. The difference amounted to a significant tax saving.
Due to the tax changes, those same clients may now permanently face an ordinary rate of 39.6% - 4.6 percentage points higher than last year. This top rate affects clients who are married and file a joint return with taxable income exceeding $450,000. Single filers will pay the new rate on taxable income of more than $400,000.
Taken on its own, this higher ordinary tax rate would now seem to make net unrealized appreciation more attractive. But there are other details to consider: The tax deal also made changes to long-term capital gains rates; there is now a "permanent" top long-term capital gains rate of 20%. That means the difference between the top ordinary income tax rate of 39.6% and the top long-term capital gains rate of 20% is 19.6 percentage points.
Advisors should also consider the new 3.8% surtax on net investment income created in the 2010 federal health care overhaul. This additional tax is imposed on the lesser of a client's total net investment income or his modified adjusted gross income exceeding the applicable threshold ($250,000 for married couples filing a joint return, and $200,000 for single filers).
IMPACT ON APPRECIATION
Since net investment income includes most capital gains income, the 3.8% surtax could affect clients selling shares of appreciated stock in their taxable account after completing a net unrealized appreciation transaction. As a result, the maximum total federal tax rate on long-term capital gains, which was 15% in 2012, could now be as high as 23.8% (20% long-term capital gains rate + 3.8% health care surtax). That's a rise of 8.8 percentage points. Put differently, the long-term capital gains rate for some clients will rise more than 50% this year from previous years. Some clients still in the 15% long-term capital gains bracket may be hit with the 3.8% surtax, making their effective rate 18.8%.
It's worth noting that although 401(k) and other retirement account distributions are not considered investment income and are not subject to the 3.8% surtax, net unrealized appreciation is taxed as long-term capital gains when sold in a client's taxable account - and those capital gains will be subject to the 3.8% surtax. That means a net unrealized appreciation transaction effectively turn surtax-exempt assets into assets that could be impacted by the tax. As a result, the potential tax saving is reduced to 15.8 percentage points (39.6% top ordinary rate - 23.8% top capital gains rate, including surtax = 15.8). It's nothing to ignore, but it's still not as good as 20 points.
2 KEY QUESTIONS
There are other issues to consider. Once the stock is moved to a taxable account, it loses the tax-deferred status it has within an IRA or 401(k). Until the stock is sold, a client still has tax deferral (since capital gains are not taxed until sold). But once the stock is sold, any gains will be subject to the capital gains rates in effect at the time. In addition, the stretch IRA is lost on the net unrealized appreciation stock.
You can help clients decide whether net unrealized appreciation is right for them based on two key questions:
* Has there been significant appreciation in the value of the company stock in their plan? Obviously, the greater the appreciation, the more this strategy makes sense. Remember, the long-term capital gains rate applies only to the appreciation, while the cost of the stock when purchased in the plan is taxed at ordinary rates. If the cost of the shares is high in relation to the amount of appreciation, the loss of the tax deferral may not be worth the trade-off.
* When does a client intend to use the proceeds? The sooner the client plans to use the money, the more this strategy makes sense. In fact, if the client intends to use the money relatively soon, it might make sense even when there has been very little appreciation. On the other hand, if the client does not intend to use the money for a long time, the net unrealized appreciation strategy may be less beneficial.
Here's an example: Your client has been working for Company X for 10 years and has accumulated $100,000 of company stock in her 401(k) plan. The cost of the shares when purchased totals $90,000. Your client recently left the company and is evaluating her tax planning options. Generally, net unrealized appreciation would not be an appropriate strategy because your client would owe ordinary income tax on the $90,000 and get a tax break only on the $10,000 appreciation - and be giving up the tax-deferred cocoon her retirement account provides.
If, however, she told you she was planning to use her entire 401(k) balance to buy a vacation home, net unrealized appreciation would make sense. After all, if she's going to pay tax on everything right away, she might as well enjoy the lower long-term capital gains rate on at least some of the money.
The basic rules come down to this: The greater the appreciation on the employer's securities within a client's qualified plan, and the sooner the client may need the money, the more the strategy makes sense. But if the appreciation of the securities has been relatively modest or if the client does not intend on using the money for a long time, you may need another approach.
Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer and an IRA distribution expert, professional speaker and author of many books on IRAs.