Traditionally, most retiring employees roll their 401(k) assets into an IRA rollover account to continue the tax-deferred growth. IRA assets are eligible for withdrawal without penalty after age 59 ½, with distributions taxed at ordinary income tax rates. Generally, you never want to take a cash distribution from your 401(k), unless you have highly appreciated company stock.
For example, say you have $400,000 of your company’s stock in your plan for which you only paid $50,000. You have a net unrealized appreciation (NUA) of $350,000. The unrealized appreciation is the difference between your cost basis and the value of the shares at the distribution date.
When you leave the company, or retire, and take a lump sum distribution, NUA rules allow you to transfer the company stock out of your 401(k) to a brokerage account. All other assets held in the 401(k) plan must be rolled over into an IRA to avoid ordinary income taxes.
In above instance, you will pay ordinary income tax only on the shares’ cost basis, not the fully appreciated market value of the stock. That means you are paying ordinary income tax rates on $50,000—not $400,000. The NUA of $350,000 is taxed as long-term capital gains; however, any price increase above the NUA becomes subject to normal capital gain rules when the stock is sold. If you rolled over your company stock into an IRA, you will be taxed at your ordinary income tax rate when you take distributions from the IRA.
Currently, there are two federal capital gains tax rates. For taxpayers in brackets less than 39.6%, capital gains are taxed at 15%. For those in the highest tax bracket, capital gains are taxed at 20%. Therefore, there could be a substantial tax savings related to the NUA amount.
There are many considerations to work through before you will know if this is the right strategy. First, consider if you would be subject to early withdrawal penalties. NUA does not bypass the typical early withdrawal rules. Second, your 401(k) plan must allow for this type of distribution. A thorough tax analysis may be helpful to determine what your tax liability would be today, compared to estimated future tax costs. Always be aware, tax laws and rates are subject to change.
This could be one of the most valuable strategies available to retiring employees; however, it is also one of the most underused tax rules because of its complexity. Before pursuing this option, it is important to plan ahead and seek advice from a qualified tax adviser.
If you have questions regarding highly appreciated company stock you own, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
