Got Employer Stock?
Monday, November 29th, 2010 by Cass Chappell, CFP®
How to take advantage of Net Unrealized Appreciation (NUA) in a 401(k)
Employer stock inside a 401(k), or other tax-deferred employer sponsored retirement plan, is quite common for employees of large publicly held corporations. Unfortunately, another common trend among several American corporations in the last several years has been significant layoffs. But before former employers attempt to roll those shares over, they should consider the tax implications specific to these investments.
There is a special tax rule that may benefit any (former) employee who finds themselves holding company stock. The term is Net Unrealized Appreciation (NUA). NUA allows for a lump sum distribution of employer stock to be taxed as income to the extent of its cost basis, or it’s purchase price. The difference between the cost basis and the current market value is known as the capital gains, which are taxed at the ordinary income tax rate.
This screams for an example:
- Mary has $500,000 in company stock in her 401(k)
- Mary only paid $200,000 for this stock throughout the years
- She takes a lump sum distribution-in-kind of this stock from the retirement plan, moving the proceeds to a bank account, brokerage account or other non-tax deferred retirement account (more on this later)
- $200,000 is taxable as ordinary income (her cost basis)
- When she sells the stock the $300,000 of NUA would be taxed as a long term capital gain (15%). Any gain from the date of distribution until the date of sale would be taxed as either short or long term capital gains (depending on whether it was shorter or longer than a year)
What does this mean?
Currently, the highest tax bracket for income is 35% and the highest tax bracket for long term capital gains is only 15%. In the example above, Mary (if she was in the highest tax bracket) would pay 35% on the $200,000 cost basis but only 15% on the $300,000 of NUA. HOWEVER, if Mary rolled the proceeds over into another tax-deferred retirement account, such as a 401(k) or an IRA, the company stock’s NUA would eventually be taxed at her ordinary income level or 35%.
Who does this apply to?
Anyone who has separated from his/her company and has employer stock in their retirement plan. If a distribution of this type is made before 55 (or in some cases, 59) then a 10% penalty may apply.
BE CAREFUL!
Financial companies have been encouraging people to rollover their old 401(k)’s for years now. BUT…If Mary rolls her old 401(k) over to an IRA, the opportunity to use the NUA rule is lost. This must be a lump sum distribution-in-kind of all stock from an employer sponsored retirement plan. If you have a 401(k) at a former employer, you should seek out a knowledgeable advisor before making any decision to move those funds.
