As plan participants have become more knowledgeable about the importance of asset allocation and diversification, the percent of assets allocated to company stock has declined. However, the total dollar amounts invested remain quite significant. Participants in plans that include company stock may benefit from learning about distribution options, including understanding net unrealized appreciation (NUA) strategies.
At the end of 2013, about seven percent of 401(k) plan assets were invested in company stock1. Older plan participants had slightly higher allocations (7.1% of account balances), while younger participants had smaller allocations (5.4% of account balances)2. Overall, company stock comprised $470 billion of the $5.0 trillion invested in 401(k) plans3. Yet, few plan participants realize that it may not be a good idea to treat company stock as they would other plan assets when changing jobs or retiring.
Net unrealized appreciation strategy
Traditional 401(k) to IRA rollovers are valuable options for plan participants who are leaving their companies. Their retirement savings may continue to grow tax-deferred. Any additional earnings may grow tax-deferred and, when distributions are taken, the money will be taxed as ordinary income. However, a rollover into an IRA may not be the most beneficial choice for participants who count appreciated company stock among their 401(k) plan assets because it may be possible to take advantage of a potential tax break related to net unrealized appreciation. This option is explained explicitly in IRC Section 402(e)(4).
NUA is the difference between the amount paid for the stock (a.k.a. the cost basis) and the current value of the stock. If company stock is distributed in-kind, NUA becomes the unrealized capital gain associated with the stock. Since long term capital gains tax rates currently are lower than ordinary income tax rates, an NUA strategy may offer a significant tax advantage.
For example, a fictional participant—we’ll call him Max—is leaving his company. His 401(k) plan account is valued at $750,000. A portion of his account is invested in company stock. The stock is worth $250,000. Max’s cost basis was $50,000, so the NUA is $200,000. Max has three basic options:
- Rollover the entire amount. Max can rollover the $750,000 account balance into a Traditional IRA, and owe ordinary income tax when he takes distributions.
- Possible tax ramifications: If you assume a 28% tax bracket for Max, and the value of the account remains constant, he’ll pay about $210,000 in taxes over time.
- Have the stock distributed in-kind and sell it. Max can rollover $500,000 into a Traditional IRA, and have the $250,000 in company stock distributed in-kind to a taxable account. If he sells the stock immediately, he’ll owe ordinary income tax on $50,000, and long term capital gains tax on $200,000 (provided that the stock in question was held for at least a year and a day).
- Possible tax ramifications: Max pays 28% on $500,000 or about $140,000 over time. He owes 28% on the $50,000 cost basis of the stock, which is $14,000 in taxes. He’ll owe 15% capital gains tax on $200,000, which is about $30,000. With this option, Max pays roughly $184,000 in taxes. That’s a potential tax savings of about $26,000.
- Have the stock distributed in-kind and hold it. Alternatively, Max could take the stock in-kind and not sell it. He’ll still owe ordinary income taxes on the $50,000 cost basis, since it is a distribution from his retirement plan, but the NUA remains untaxed until Max sells the shares and the gains are realized.
It’s important to note that the stock could gain or lose value or the capital gains rates could change over time. If the stock loses value or the capital gains rates increase, then some or all of the tax advantage gained through an NUA strategy could be lost.
Special considerations
In some circumstances, a rollover may be the right choice even for appreciated company stock. For example,
- If a significant portion of your wealth is held in company stock, you may want to rollover the assets to improve your tax-deferred portfolio’s diversification.
- Assets held in IRAs and employer-sponsored retirement plans may be better protected from creditors than those in held taxable accounts.
- If you’re a couple of decades from retirement, tax-deferred growth might provide a bigger financial advantage than an NUA strategy.
Executing an NUA strategy is not always simple or straightforward. Plan participants should work with their tax and financial advisors to determine whether they qualify for the strategy (the IRS enforces the qualification rules strictly), and whether the strategy makes sense for them. In addition, they should discuss considerations like penalty taxes, portfolio diversification, loss of tax-deferral, and required minimum distributions.
- VanDerhei et al. 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2013, p. 1, December 2014 [https://www.ebri.org/pdf/briefspdf/EBRI_IB_408_Dec14.401(k)-update.pdf]
- Investment Company Institute, 2015 Investment Company Fact Book, p. 146 [http://www.icifactbook.org/pdf/2015_factbook.pdf]
- U.S. Department of Labor. Private Pension Plan Bulletin: Abstract of 2013 Form 5500 Annual Reports, June 2, 2015 [http://www.dol.gov/ebsa/pdf/2013pensionplanbulletin.pdf]
Before retirement, Terry Dunne was the senior vice president and managing director of Retirement Services at Millennium Trust Company, LLC. Mr. Dunne has over 40 years of consulting experience in the financial services industry. He has written extensively on retirement planning, industry trends, technology, and legislation. Millennium Trust performs the duties of a directed custodian, and as such does not sell investments or provide investment, legal or tax advice.
