I often work with clients on the cusp of retirement who hold company stock in their employer-sponsored 401k accounts. The client wants to move the account balance to an IRA, but isn’t sure what to do with the company stock and the plan administrator is of little help.
The IRS permits tax-free rollovers of company stock to an IRA. When the company stock is later distributed from the IRA, the stock is taxed at ordinary income tax rates based on the stock’s fair market value on the date of distribution. That fair market value then becomes the basis for computing capital gains or losses on the future sale of the stock.
This strategy often presents a tax problem for the employee. The stock’s value may have appreciated considerably since acquired in the 401k. The employee faces the loss of capital gain treatment on the stock sale when distributed from an IRA post-rollover. Selling the stock inside the IRA doesn’t offer any benefit either, because the proceeds will be taxed as ordinary income when distributed from the IRA.
However, it may make sense to distribute all of the company stock from a 401k instead of moving it to an IRA.
This move offers a couple of strategies that can work to reduce any tax bite to manageable levels. The first strategy, which we’ll discuss in this post, is to take advantage of net unrealized appreciation (NUA) treatment on a distribution of company stock from a 401k.
NUA treatment allows the employee to take company stock from a 401k and pay ordinary income tax on the original cost of the stock (basis), rather its fair market value when distributed. The difference in the stock’s basis and its fair market value at distribution is the NUA. The NUA is not taxed when the stock is distributed provided the employee removes ALL of the employer stock from the 401k. The tax on the NUA can be deferred until the stock is sold, and the NUA (along with any post-distribution gain) is taxed as long term capital gain. (Capital gains tax rates range from 0 to 15% to 20%.) And, the long term capital gain on the NUA is not subject to the extra 3.8% tax on net investment income.
To qualify for NUA treatment, the company stock must be the stock of your employer. So, if you work for Apple, you can’t get NUA treatment for Amazon stock held in your 401k. The distribution must be a lump sum of the entire 401k account balance taken in one tax year. The distribution must occur after a qualifying event such as separation from service, reaching age 59½, death, or disability. The balance of the plan assets (non-company stock, etc.) can be rolled over tax free to a traditional IRA or another company plan.
Dealing with company stock in an employer plan account is never easy. You must consider many factors before making a decision. There are tax traps to avoid. Make sure you are working with a knowledgeable advisor when considering which option is best.
In my next post, we’ll look at the other strategy available to deal with company stock in a qualified plan account. Until then, if you are confused about handling a retirement plan distribution or rollover, give me a call, I can help.