Taking advantage of the special tax break for net unrealized appreciation on lump-sum distributions from a retirement plan most often was a fairly simple decision, but given all the tax changes that took effect at the dawn of this year, that is no longer the case.
Although using NUA can still make sense, deciding whether to take advantage of it has become more complicated, so it is time to re-evaluate the benefits of an NUA transaction.
NUA seeks to take advantage of the disparity between long-term capital gains rates and ordinary income tax rates, essentially allowing clients to trade the latter for the former on a portion of their retirement savings if they qualify under the lump-sum-distribution provisions and have a triggering event.
When the American Taxpayer Relief Act of 2012 was signed into law at the beginning of this year, it changed both ordinary income tax and long-term capital gains rates. Plus, the additional 3.8% health care surtax on net investment income, which includes capital gains, took effect at the start of the year.
As such, financial advisers should take a fresh look at the NUA strategy to see which of their clients may be affected by these changes and whether NUA may continue to make sense as part of a client's overall plan.
In order to use NUA, clients must have appreciated securities (usually stock) of their employer inside a qualified plan. After a triggering event — such as death, reaching 591/2, disability (self-employed only) or separation from service (not for self-employed) — they must take a lump-sum distribution, emptying all like plans in one calendar year and move the securities to a taxable (nonqualified) account.
If the distribution is done properly, ordinary income tax is owed in the year of the NUA transaction on the original cost of the shares, and long-term capital gains are owed on the remaining appreciation — but not until those shares are sold in the taxable account. They can be sold at any time, allowing flexibility in tax planning.
NUA is taxed at long-term capital gains rates no matter when the stock is sold. This is true even if the client dies and a beneficiary sells the stock.
NUA is an item of income in respect of a decedent and doesn't receive a step-up in basis at death.
For clients in the highest tax bracket, NUA will be slightly less beneficial in 2013 and later than it has been for the past several years but will, in many cases, still prove to be a useful strategy.
Last year, clients in the highest ordinary-income bracket who took advantage of NUA would have effectively traded ordinary income tax of 35% for long-term capital gains tax of 15% on a portion of their retirement funds. The 20-percentage-point difference was a significant tax savings.
Under the ATRA, in 2013, those clients may now permanently face an ordinary rate of 39.6%, 4.6 percentage points higher than last year.
This top rate hits clients who are married and file a joint return with taxable income above $450,000. Single filers will pay the new rate on taxable income above $400,000.
Taken on its own, this would make NUA more attractive in 2013 and future years. However, the ATRA also made changes to the long-term capital gains rates, and the new top rate is permanent at 20%.
In addition, as part of the 2010 health care acts, a 3.8% surtax on net investment income was created that began to affect certain high-income clients at the start of this year. It is imposed on the lesser of a client's total net investment income or modified adjusted gross income over the applicable threshold. For married couples filing jointly, this threshold is $250,000 of MAGI. For single filers, it is $200,000.
Because net investment income includes most capital gains income, the 3.8% surtax could affect clients selling shares of appreciated stock in their taxable account even after completing an NUA transaction.
As a result, the maximum total federal tax rate on long-term capital gains — 15% last year — could now be as high as 23.8% (20% long-term capital gains rate plus 3.8% health care surtax). That is an increase of 8.8 percentage points.
Put differently, clients could be paying more than half again as much tax on their long-term capital gains in 2013 as in previous years. Also, some clients in the 15% long-term capital gains bracket may be hit with the 3.8% surtax, pushing their rate up to 18.8%.
Altogether, the potential tax saved on an NUA transaction is now reduced to 15.8% (39.6% top ordinary rate minus 23.8% top capital gains rate, including surtax).
Ed Slott (irahelp.com), a certified public accountant, created The IRA Leadership Program and Ed Slott's Elite IRA Advisor Group.