Often-times, publicly traded companies will offer company stock to their employees in their retirement account. This employer stock offers a unique tax-advantage upon withdrawal of funds – allowing you to access a portion of your retirement account at favorable long-term capital gains rates as opposed to income tax rates through net unrealized appreciation.
Whenever a purchase of company stock is made in your 401(k) it gets tracked as part of your company stock basis. Over time, ideally the company stock will appreciate in value and that is where the tax advantage becomes possible.
Let’s say you work for ABC Co. and buy shares of ABC stock each time you make a contribution to your 401(k). ABC stock performs tremendously well over your career with the company and you successfully retire. If we assume that the basis in your ABC stock is $50,000 (the amount that you paid to buy the shares over time) and the shares grew to be worth $500,000 you have a net unrealized appreciation opportunity amounting to $450,000.
In this situation, you can elect to distribute the $500,000 of ABC stock into a taxable brokerage account. Instead of owing income taxes on the full $500,000, you would only owe income taxes on the $50,000 worth of basis in the year that the stock was distributed. For the remaining $450,000, that would become a long-term capital gain that would be owed upon sale of the shares.
How much would this save you in taxes? If we assume you are in the 24% tax bracket on average (we won’t factor in the potential of bumping into a higher tax bracket to keep the math simple) you would owe $120,000 in income taxes for the distribution of the $500,000 worth of stock. Utilizing net unrealized appreciation, you would owe $12,000 in income taxes for the basis of the shares and $67,500 for the long-term capital gains of the remaining $450,000 – if we assume a 15% long term capital gains rate – for a total of $79,500. In this example, the net unrealized appreciation would have saved you approximately $40,500 in taxes.
There are a few things to note if you are going to utilize net unrealized appreciation. First, the IRS requires that all of the funds be distributed from your 401(k) by year end to utilize the rule. You don’t need to take the remaining funds as a taxable distribution but you will need to roll the funds into another retirement account. Additionally, the early withdrawal penalty will still apply for the basis portion of the distribution if you are under age 59.5 and don’t qualify for an exemption. That said, the growth portion will not be subject to the early withdrawal penalty.
In order to determine whether net unrealized appreciation is right for you, you will want to consider a number of items:
- How large is the gain relative to the basis? If the basis is a significant part of the total distribution it may not be worth realizing the income taxes all in one year – though you do have the ability to complete NUA for just a portion of the stock
- Are you comfortable continuing to hold the company stock? You will ultimately have to realize the long-term capital gains to diversify away from company stock. If diversification is important to you, you don’t need the funds in a short period of time, and your company stock is a large component of your overall portfolio it may be more prudent to simply diversify in your retirement accounts and pay the income taxes when you need the funds down the road.
- Do you need the money soon? If you are not in retirement, or alternatively if the company stock makes up a large portion of your overall retirement funds it may make sense to continue to hold the funds in your retirement accounts or complete NUA with only a portion of the company stock.
While the tax benefits can be appealing, one should consider how the distribution of the stock will affect them in the long term. There will be a loss of tax deferral when the stock is removed from the retirement account that can have tax implications depending on your goals and needs for the funds.
If you’d like to discuss any of these strategies and how they might apply to your situation, schedule a meeting with our team here.
If you’d like to sign-up for our monthly newsletter with four high-quality, financial planning focused posts per month, click here.
Disclosures: Any opinions are those of Michael Dunham and not necessarily those of Raymond James. The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Hypothetical examples are included for informational purposes only.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.