While it’s not quite as common these days, there are still several large, well-known and well-established companies that give their employees company stock in their 401(k). We’ve seen several clients who have invested both their 401(k) contributions and their company match into the stock of the same company that they work for.
In our opinion, this is one of the biggest mistakes they can make as an investor. Quite often we don’t recommend that individuals ever invest in the company they work for, because then both their income and retirement are dependent on one company. This concentration risk can be detrimental should they lose their job or if the company were to close down.
As you’ve heard us say before, we recommend that investors have no more than 5% of their investable assets in one company. However, we’ve seen many investors from big companies like Home Depot, United Parcel Service, Coca-Cola, and Procter & Gamble have 30 to 40 years of retirement investments tied up in their company stock. Many of these investors are willing to take on the concentration risk because they’re being given the stock as incentives, bonuses, or as matching retirement plan contributions. They see their company as diversified with 50 or more product lines; however, the company is still only a player in one sector. While the product line may be diversified, the fact remains that the concentration risk is still large.
For example, you may want to retire in 2022, and your company stock investment is worth more than a million. However, when 2022 rolls around, what if the market suddenly looks like it did in 2008 and your company stock is worth half of what it was. Maybe you make the decision not to retire. Or what if the market is more like 2015, reaching all-time highs and your company is going through what General Electric went through, where their stocks just kept falling? This is the problem with concentration risk. Additionally, that scenario is not the purpose of financial planning. Your goal has been to invest in your future and to have the money available to support the lifestyle you want.
While diversifying investments is our No. 1 recommendation, investors in such a situation do have one potential benefit: net unrealized appreciation (NUA).
When you 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. This is a taxable event; however, you would only owe ordinary income tax on the shares’ cost basis, not the fully appreciated market value of the stock. If you have $1 million in company stock, your cost basis from the past 30 or 40 years might be around $100,000, potentially giving you an NUA of $900,000, which then would be taxed as long-term capital gains when sold from the brokerage account. Likewise, any price increase above the NUA becomes subject to normal capital gains rules when the stock is sold. The highest tax on long-term capital gains is 20%. Alternatively, if you rolled over your company stock into an IRA, withdrawals would be taxed as ordinary income tax rate, which could be as high as 37%.
This could be one of the most valuable strategies available to retiring employees who have a significant amount of assets in company stock; 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 as these moves are taxable events and could disrupt other tax strategies you have in place.
If you have questions regarding how taking advantage of NUA might work in your situation, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166