Stock Lots and NUA

Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in California is representative of a common question on net unrealized appreciation (NUA) and stock lots.

"Can plan participants select specific stock lots as part of an NUA election?"

Highlights of the discussion on NUA and stock lots

What follows is for informational purposes only and is not tax or legal advice.

The facts of the case: The client was 61 years old and had recently retired. He was planning to take a lump sum distribution from his 401(k) plan. The value of his account balance was approximately $1.4 million of which $900,000 was invested in employer securities. The advisor was familiar with the NUA special tax treatment option for lump sum distributions that contain employer stock but had some concerns. The basis of the employer securities was approximately $500,000.

Because this scenario involves a very intricate tax question, we encouraged the advisor to involve his client’s tax professional for specific tax advice. Generally, NUA is the gain in value of employer stock while it is held within a qualified retirement plan. The basis is the value of the employer stock when it was purchased in or contributed to the plan. NUA has special tax rules; NUA in employer securities is taxed at the long-term capital gains tax rate when the stock is sold outside of the plan if certain conditions are met (see IRS Notice 98-24 and Lump Sum Distribution Triggers and NUA).

In this case, because the basis was a large portion of the overall value of the stock, the advisor was concerned an NUA strategy might be less advantageous compared to an IRA rollover. After discussing the issue in greater detail, it was noted that the stock had experienced a significant increase in value approximately 12 years ago. We reviewed the client’s plan statements and noted this company stock price increase.

Next, we reviewed the basis of these early stock lot purchases and identified approximately $390,000 of stock with a basis of only about $60,000. Generally, an NUA option is more advantageous when the basis is significantly smaller than the current stock price. The advisor and his client were unaware specific stock lots, potentially, could be selected for NUA purposes and believed an NUA election was an all or nothing calculation.

Provided the appropriate stock lot purchase records are available, specific stock lots can be selected as part of an NUA election. In fact, Treasury Regulations at 1.402(a)-1(b)(2)(ii) provides four methods to attribute basis in employer stock. The plan, in this case, used the first of these methods to attribute basis to that specific participant and to specific stock lot purchased. As noted previously, the early stock lots with a lower purchase price have a reduced basis making a partial NUA election possible.

After our discussion, the advisor met with his client and the client’s CPA to further consider a NUA election for the selected stock lots.

Conclusion

Because an NUA election is a very nuanced tax question, plan participants should always seek specific tax advice from their own tax professionals. Provided the appropriate stock lot purchase records are available from the plan, participants may be able to select specific stock lots as part of an NUA election, if they meet all other requirements for a NUA tax strategy.