In railroads that are publicly traded, it’s commonplace to reward railroaders with the railroads’ stock, often granted directly in/through profit sharing or ESOP plan, or at least by allowing railroaders to purchase shares themselves inside their 401k plan. The advantage of this strategy is that it helps to encourage an “ownership mentality” by the railroaders, who literally become shareholders in the railroad. The disadvantage, however, is that when the railroad stock is purchased/owned inside a retirement account, it is ultimately taxed as ordinary income when withdrawn(as is the case for any distribution from a retirement account), and loses the opportunity to take advantage of long-term capital gains rates.
To help address this situation the Internal Revenue Service allows railroaders a special election to distribute appreciated railroad stock out of an railroaders retirement plan, and have the “Net Unrealized Appreciation” (i.e. the embedded capital gain) taxed at favorable capital gains rate outside of the account. However, to take advantage of these special NUA rules, there are specific requirements that the stock must be distributed in-kind, as part of a lump sum distribution, after a specific triggering event.
In order to meet the requirements for the NUA rules, there are three very specific requirements that must be met:
The railroad stock must be distributed in-kind. This means it must actually be true railroad employer stock, that is able to be transferred in-kind.
The railroad’s retirement plan must make a “lump sum distribution”. A “lump sum distribution” means the entire account balance of the railroad’s retirement plan must be distributed in a single tax year.
The lump-sum distribution must be made after a “triggering event” In order to be eligible for the NUA treatment of an in-kind distribution of the railroad’s stock, the lump-sum distribution must be made after a triggering event. The triggering events are:
Separation from Service
Reaching age 59 1/2
The upside of the the NUA strategy is that it establishes an opportunity to convert unrealized gains from ordinary income rates into lower tax rates on long term capital gains instead. However, the caveat is that in order to use the NUA rules, the railroader must report the cost basis of the stock immediately in income for tax purposes, and pay tax at ordinary rates. In addition, if the NUA stock is quickly sold, that long term capital gains bill immediately comes due.
Therefore, the NUA rules don’t merely allow for the gains to be taxed at lower rates. They cause the gains to be taxed at lower rates immediately (at least if the stock is sold immediately), in addition to triggering ordinary income taxation of the cost basis immediately, when all of those tax liabilities might otherwise have been deferred for years or decades. This leaves the railroader having to decide whether to take advantage of the NUA strategy or not. It is really more of a trade off, than guaranteed tax savings success.
As a result, the best practice for NUA distributions is to really understand the cost basis of the railroad’s stock inside the 401k, and if necessary choose only the lowest basis shares for the NUA distribution to guarantee the most favorable tax outcome. Luckily, the NUA rules do allow such options to take some shares in-kind, and roll over the rest. But that still means it’s necessary to actually do the analysis to determine whether or how many of the NUA eligible share should actually be distributed to take advantage of the strategy.
Railroaders who stand to gain the most from the NUA strategy are those with highly appreciated railroad stock or higher predicted future tax rates. However, a customized analysis by a qualified railroad retirement planner is recommended to crunch the numbers and make an informed decision about the strategy that is best for your retirement goals. If you would like to discuss your railroad retirement stock strategy, please schedule a free meeting.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. Highball Advisors encourages you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Highball Advisors, and all rights are reserved.from Highball Advisors, and all rights are reserved.