According to a recent study, the median tenure for CEOs employed at a large-cap company is now just five years, which is down from six years in a similar study done in 2013. Are we saying you should be concerned about your employment outlook? Of course not, but new job opportunities arise all the time, and you never know when you might decide to make a move.
As an executive, you will likely face the decision of what to do with a prior employer’s equity compensation plan when you move on. One of the most effective strategies to utilize at this time involves your net unrealized appreciation, and it could make a big difference in the amount of tax you pay on your stock from a previous employer. To better prepare you for the nearly inevitable financial planning that will be needed when you change employers, let’s outline some net unrealized appreciation rules and strategy options that can help you when the time comes.
Learn more about the equity compensation planning services offered by the Carpenter Team.
What Is Net Unrealized Appreciation?
This financial term, like many others, is easily defined by dissecting the words. Net unrealized appreciation is the net amount of appreciation accumulated within company stock that is unrealized until the stock is sold. It truly is the difference between the original cost of the stock and the current market value.
For example, if you purchased 100 shares of company stock at $20 a share ($2,000) and the current market value on the stock is $40 per share ($4,000), your net unrealized appreciation would be the current market value ($4,000) minus the original cost or cost basis ($2,000) which gives you $2,000 in this case.
To implement a net unrealized appreciation strategy, you would work with your financial advisor to move your employee-owned stock that is held in a qualified plan, such as a 401(k) plan, over to a non-qualified account, such as a brokerage account. This allows you to lower your tax bill when you sell the stock. How? By paying ordinary income tax on the original basis and capital gains on the growth.
To better understand this, let’s take a closer look at the net unrealized appreciation rules and at an example of how this strategy can be beneficial for corporate executives.
Net Unrealized Appreciation Rules: How to Qualify
One of the net unrealized appreciation rules, per the IRS, is that your lump sum distribution from your previous employer must be reported as an amount in box 6 of your Form 1099-R for net unrealized appreciation in employer securities. Once you ensure that your employer does this, you are then eligible to explore this type of strategy further. There are some other net unrealized appreciation rules that you must meet as well, including:
- You must distribute the entire vested balance of your qualified retirement plan within the same tax year.
- You must distribute the entirety of assets from all qualified plans you hold with your previous employer.
- You must move the distribution of company stock over “in kind.” In other words, you cannot sell the shares for cash before the distribution into the new account.
- You also have to meet one of the following criteria:
- You no longer work for the employer from which you are moving your funds.
- You are older than age 59½.
- You are eligible to claim total disability.
- You pass away (in which case, your survivor can utilize this strategy).
Now that you have an understanding of the rules put in place by governing bodies that you must meet, let’s take a look at the strategy behind net unrealized appreciation and when it might make sense.
Net Unrealized Appreciation Strategy Options
To better illustrate a net unrealized appreciation strategy, let’s look at a hypothetical example of an executive who we would typically help through this process.
Tom is an executive at a large corporation, and he just turned 60 years old. Rather than throwing an elaborate birthday party for himself, he decides to tackle a new job opportunity in which he will be consulting for multiple corporations. He knows he wants to move his old company stock out of his prior employer’s plan, but he also wants to minimize the amount of tax he will pay when he does this. He is in the highest tax bracket, so his income tax level is 37%, and his capital gains tax level is 20%.
Tom currently holds $500,000 worth of his previous employer’s stock and his cost basis on that stock (the amount he paid) is $100,000, which gives him a net unrealized appreciation value of $400,000. He would like to use that money to invest in his new business venture. Because of this, he opts to utilize a net unrealized appreciation strategy and move the stock into a taxable brokerage account. He plans to sell the stock as soon as it hits the brokerage account, so he would need to pay income tax (37%) on the cost basis ($100,000) and capital gains tax (20%) on the net unrealized appreciation ($400,000) bringing his total tax bill to $117,000. This would leave him with $383,000 to start his new business venture.
In contrast, if he would have chosen to move the company stock over into another qualified plan and then sell the stock and pull out the cash, the entire amount ($500,000) would have been subject to income tax, resulting in $185,000 in taxation. This would have left Tom with only $315,000 to start his business. By employing a net unrealized appreciation strategy, Tom gets to keep an extra $68,000 in his pocket to begin his new venture.
Work With an Expert
It’s important to note that when you are exiting from an executive position, no matter your next move, it is in your best interest to work with an experienced executive financial advisor. A truly effective advisory team can help you decide how to best leverage your old equity compensation by minimizing taxation and maximizing outcome.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for equity compensation planning, including implementing net unrealized appreciation strategies.
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