That Company Stock in Your 401k Can Save You a Bundle in Taxes
We recently sat down with a new client to review his investment portfolio and discuss his retirement goals. Robert is just three years away from retirement after a 20 year career with Verizon. As we began to review his 401k plan, Robert grew visibility uncomfortable, looking up and away as if he was expecting the roof to cave in on top of him. A quick glance at his 401k investment accounts revealed the source of his discomfort. He had $780,000 accumulated, divided equally into a portfolio of funds and his company’s stock.
It was clear that he was expecting his new financial advisor to go off on some diatribe about the lessons of Enron or WorldCom, and the idiocy of holding so much of his retirement security in a single company stock. Instead, he was floored when I congratulated him and told him he was in a great position so close to retirement. Huh?
While it is true that we can’t ignore the lessons of Enron and WorldCom in which thousands of people lost their entire retirement savings when the companies’ stocks collapsed, Robert’s situation is very different and, in fact, very advantageous. Of course, Verizon, being one of the largest and most established communications providers in the world, is not Enron, which helps us overlook the high concentration of Robert’s 401k investment in company stock. But, the real advantage Robert has is the highly favorable tax treatment he can enjoy under special provisions in the tax law that could save him tens of thousands of dollars. Let me explain.
How it Works
Buried deep in the voluminous tax code is a little known provision that deals with company stock contained in 401k plans. It’s call Net Unrealized Appreciation (NUA) and it allows planholders to take advantage of much lower tax rates on the unrealized appreciation of your company’s stock. Essentially, when you withdraw company stock from your 401k account, you are taxed only on the original cost of the stock. Later, when you sell the stock for a gain, you will pay taxes at the lower capital gain rate. But, it gets better.
When you take the distribution from your 401k plan, it has to be in the form of a total Lump Sum Distribution made in single calendar year. So, everything, including the company stock needs to be withdrawn. Funds that are not in company stock are rolled over into an IRA, and the company stock is moved into a taxable investment account such as a Charles Schwab brokerage account. If you sell any of the stock before moving it, you will lose the NUA treatment. At the end of the tax year, you will then pay ordinary income taxes on the cost basis of the stock. Your 401k administrator can help you with that information. The remaining stock can be left to grow until such time as you need the funds and will be taxed at the lower capital gains rate.
For Robert, who has $380,000 of company stock and a cost basis of $100,000, his initial tax on the withdrawal would be at his ordinary income tax rate of 25 percent, or $25,000. The remaining NUA share balance of $280,000 will be left to grow in his taxable account. At any time, Robert can sell the stock and pay the tax at the capital gains rate of 15 percent.
Verizon stock has increased at a rate of nearly 7 percent per year over the last five years. If it continues at that rate of growth for the next 10 years, his NUA share balance will grow to more than $500,000, however, instead of paying as much as $125,000 in ordinary taxes on the gain, he would only pay $75,000 in capital gains taxes.
Alternatively, Robert could roll his $100,000 of basis stock into an IRA along with his other funds, which will enable him to avoid paying ordinary income taxes on the distribution. He could then move the remaining stock allocated to NUA to a taxable account thereby paying no taxes at all.
Seek Professional Guidance
Although these strategies are allowable by the tax code, it would be very important to work with your tax advisor to ensure the procedures are followed correctly. Additionally, it would be important to fully assess your personal tax situation and retirement income needs to ensure this strategy is right for you. If you own your company’s stock inside your 401k plan, and would like to explore your distribution options, please don’t hesitate to contact us.