There are many people that have worked for the same company for ten, twenty, or even forty years. Certainly, in today’s environment, this isn’t as common anymore, but – according to Morningstar – 10% of total assets in company retirement plans are still invested in employer stock1. What’s their biggest perk? It’s not a gold watch or even retiree medical insurance. It is the company stock that they have been buying inside their company 401(k) or Employee Stock Ownership Plan (ESOP). Why? The IRS gives special tax incentives for owning employer stock inside your retirement plans referred to as Net Unrealized Appreciation (NUA).
We had a client that came to us while working for an oil company. He had worked at this oil company for twenty-five years, was a few years away from retirement and was looking for help getting organized to see when he would be able to retire and how he should be positioning his investments now to limit his risk. He had about 70% of his $1.5M 401(k) invested in his employer stock. He had heard about NUA from a coworker and asked us about it. It is a slightly complicated process, so he wanted to learn exactly what and how to do it.
The first step is to roll the portion of your 401(k) or ESOP that is your company stock into a non-qualified investment account. This is an account that is titled in your own name individually, joint with your spouse, or in the name of your living trust (see your attorney for a recommendation on how to title the account that is right for you). Normally, rolling qualified retirement funds into a non-qualified account triggers ordinary income tax on the total amount that was rolled over. But, with employer stock, the IRS allows special treatment. The cost basis of the employer stock becomes ordinary income taxable to you in the year of the rollover. The difference between the current market value of the company stock and the cost basis is taxed as long-term capital gains when you sell the stock.
If you don’t sell any of the employer stock once it is in the non-qualified account, then you don’t pay any additional tax until you sell it. When you sell the stock, the difference between the cost basis and the value when you did the rollover is taxed at long-term capital gains tax rates, and the difference between the value at rollover and the price you sell it for (if there is one) is taxed as long or short-term capital gains rates depending on the holding period.
Let’s take an example: Mary is age 62, has worked at UPS for twenty years and she has about 50% of her $800,000 401(k) in UPS stock. She started buying UPS stock twenty years ago and has been ever since. She thinks she may be interested in pursuing a NUA transaction, so she contacts her plan administrator to find out what the cost basis is and they tell her the cost basis on the UPS stock is $50,000. Mary has an existing account (or opens a new account) and rolls the UPS stock out of her 401(k) and into her non-qualified account. Once the UPS stock is in there, she decides to sell half of it this year and the other half next year in order to help diversify her investment holdings before retirement.
She tells her CPA that she is completing NUA and keeps an eye out for the reported forms at the end of the year. She has to include $50,000 as ordinary income, subject to her marginal rates. Assuming the total UPS stock that was rolled over was $400,000, she sold $200,000 the same year and must pay long-term capital gains tax on $200,000. There is no tax due in that year on the remaining $200,000 that she didn’t sell until the following year when she sells it. Let’s say that when she sold the remaining UPS stock, she sold it for $220,000 and it was only nine months after the transfer occurred. She would pay short-term capital gains tax on $20,000 and long-term capital gains tax on $200,000.
While Mary does forgo the tax deferral IRAs offer, she still ends up saving quite a bit of tax by doing the NUA transaction. With NUA, assuming she is in the 24% marginal tax bracket now and later, she might pay roughly $64,500 in tax. If she would have simply rolled her 401(k) into an IRA, she would have to pay tax on all of distributions from the 401(k) over her lifetime. Assuming again she is in the 24% marginal tax bracket, she would have paid roughly $96,000 in tax. This is a savings of $31,500!
Pretty simple, right!? There are two caveats that we want you to be aware of when considering taking advantage of NUA. The first one is since the distribution is made from a qualified retirement account, you must be age 59 ½ or older in order to avoid early distribution penalties. Another important thing to note is that has been talk in congress about potentially eliminating the benefits of NUA for folks under age 50. One primary reason for changing the law is that the way it stands now, it incentivizes employees to buy employer stock in retirement accounts, but over-concentration in one stock is not usually the safest idea due to lack of diversification, especially as you approach retirement.
We encourage anyone in a similar situation to contact one of our wealth advisors to discuss the options specific to your situation. We work with your CPA and attorney to help ensure the transaction occurs smoothly and properly. Take advantage of the tax benefits while you can!
Disclaimer: Beacon Pointe does not endorse and is not responsible for the content, product, or services of other third-party sites. This article has been provided for informational purposes only and should not be considered as investment advice or as a recommendation. This material provides general information only. Beacon Pointe Advisors does not offer legal or tax advice. Private legal counsel alone may be responsible and relied upon for these purposes. Only private legal counsel may recommend the application of this general information to any particular situation or prepare an instrument chosen to implement the design discussed herein. CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, this notice is to inform you that any tax advice included in this communication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of avoiding any federal tax penalty or promoting, marketing, or recommending to another party any transaction or matter.