401(k) and Employer Stock — A Different Approach
There are a lot of large and medium-sized businesses with operations in or around Fort Collins. Many of these businesses offer a 401(k)-type plan, and some offer company stock as an investment option in their plan.
Often, when you change jobs or retire, you look at options for rolling over that old 401(k) either into your new employer’s 401(k)-type plan or into an IRA. Most of the time, either of these options tends to make a great amount of sense. However, when it comes to company stock, there is another option.
The phrase of the day here is: “Net Unrealized Appreciation” or NUA for short. NUA exists because of the way company stock is treated when it is purchased or contributed to a 401(k), profit sharing, or another qualified plan. The concept is fairly straightforward: Any time an employee purchases company stock or an employer contributes to a qualified plan account, that stock carries a tax basis, essentially what was “paid” for that stock.
To leverage NUA, the trick is to take a taxable distribution of the stock “in-kind” — rather than rolling the stock over to an IRA or another 401(k). Taking the distribution of the stock in-kind means that you receive the actual shares of stock, not the cash proceeds from their sale. If you’re under 59.5, this distribution of stock in-kind may indeed be subject to premature distribution penalty tax but, even so, the math may work out in your favor over time.
Let’s say you were 45 when you changed jobs. Over the years you spent contributing to your former employer’s 401(k) plan, you bought 4,000 shares of company stock for a total cost of $50,000. When you left the company at age 45, the stock was worth $100,000. Over the next 20 years, the stock — averaging a 5% annual return — grew to just north of $265,000. For your 65th birthday, you’ve decided that you are going to sell the stock and use it along with some other funds to pay cash for a second home.
Here’s what happens:
Only your $50,000 in cost was taxed as ordinary income and subject to the 10% premature distribution penalty tax when you took the in-kind distribution at 45. Assuming you were in the 24% tax bracket, your tax bill then was $17,000.
At sale on your 65th birthday, the next $50,000 — which is the NUA — is taxed as a long-term capital gain, capped at 15% (for most). The tax bill for this portion is $7,500, bringing the total tax bill up to $24,500.
At the sale, the last $165,000 — representing the growth over the last 20 years — is also taxed as a long-term capital gain, capped at 15%. The tax bill for this portion is $24,750, bringing the total tax bill for the entire transaction to $49,250.
Now let’s look at the more traditional approach. For simplicity’s sake, let’s say that you rolled the stock over to an IRA at age 45 and, at 65, you’re going to sell the stock in your IRA and take a cash distribution of the proceeds. Based on today’s tax rates, assuming you’re married, this distribution alone would almost surely put you into the 24% tax bracket, at least. The math here gets a lot simpler: The tax bill on this $265,000 distribution from your IRA would be $63,600, as it’s all taxed as ordinary income.
Even with a premature distribution penalty tax at 45, the tax savings here is over $14,000. Probably the biggest risk to the in-kind distribution strategy is a stock that declines in value after you take the distribution but, in all seriousness, this is the primary risk in many things investing: losing money through a decline in share price.
Finally, keep in mind that these tax bills don’t pay themselves. If you take a $50,000 in-kind distribution of stock, you need to have the cash available to pay the taxes. Unfortunately, the IRS won’t let you pay in stock.
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*This is a hypothetical financial planning scenario presented for illustrative purposes only. It should not be construed as an investment recommendation or solicitation. Please consult an advisor to discuss your individual situation prior to making any investment decision. The rates of return do not represent any actual investment and cannot be guaranteed. Any investment involves potential loss of principal.