Thus, Widget.com was born. While working at ABC, Joe contributed the maximum to his 401(k) and ABC generously matched with employer stock.
The balance in Joes 401(k) now exceeds $700,000, of which $300,000 is ABC stock with a basis of $75,000. Joe plans to roll over his 401(k) into a self-directed IRA, liquidate his ABC stock and diversify his portfolio. Although Joe already is 60 years old, he loves the widget business and has no plans to retire.
Fortunately, before Joe implemented his IRA rollover, he met with a financial adviser who told him there might be a better way. She explained that it was possible to only pay a 20 percent tax rate on his gain from ABC stock instead of his ordinary income tax rate of 39.6 percent an option that could save him thousands of dollars. Heres how it works:
If the employer stock is rolled into an IRA, Joe could sell the stock with no tax consequences and reinvest it however he liked. He would continue to get tax-deferred growth as long as the assets remained in the IRA. However, distributions would need to begin from that account by age 70 1/2, and all distributions would then be taxed as ordinary income.
If the ABC stock is taken as a direct distribution from the 401(k), only the cost basis of the stock ($75,000) is subject to the ordinary income tax rate. The difference between the value of the stock and the basis ($225,000) will be taxed at long-term capital gains rates regardless of when its sold.
The difference between the cost basis and the value of the stock at distribution is the net unrealized appreciation or NUA. Any appreciation that occurs after the distribution date would be subject to the short- or long-term capital gains rate, depending on the holding period.
Some things to keep in mind if you own employer stock in your 401(k):
- Although a direct distribution from the 401(k) would reduce the total amount of taxes owed, it would require paying a tax now instead of in the future. Current cash flow as well as your future tax bracket need to be assessed to determine if this technique is appropriate for you.
- In addition to the cost basis of the employer stock being subject to tax at the time of distribution, it also is subject to a 10 percent penalty if youre not yet 59 1/2 when the distribution is made (or 55 if separated from service).
The special tax treatment on net unrealized appreciation could save you thousands of dollars in taxes and provide you with a bigger nest egg for retirement. Whether it makes sense for you is a topic you should discuss with your financial and tax advisers. Whats important is that you make a well-informed decision.
Ruth Forsyth, CFP, is a senior account manager of market development with The Acacia Group. She co-hosts the All Things Financial radio program Wednesdays from 7-8 p.m. on KQV-AM (1410). Reach her at (412) 922-4360 or by e-mail at Ruth.Forsyth@Acacia-Pgh.com.