Whenever employees leave a job, they frequently roll over their 401(k) plan's assets into their IRA. In most cases, this is a great way to continue deferring taxes until you retire and begin taking distributions. However, if your 401(k) or other employer-sponsored retirement plan includes highly appreciated, publicly-traded stock in the company you work for, you could save thousands of dollars by paying taxes on the stock now rather than later.
How Not Rolling Over Can Mean Less Tax
When you distribute money from your IRA, you pay ordinary income taxes on those distributions (assuming your original contributions to the account were made with pre-tax dollars). Company stock rolled into the IRA is treated the same way.
But if you withdraw your company stock from your 401(k) and, instead of rolling it into an IRA, transfer it to a taxable brokerage account, you avoid ordinary income taxes on the stock's net unrealized appreciation (NUA) (regardless of whether you sell or continue to hold the stock). The NUA is the difference between the value of the company stock at the time it was purchased (and put into your 401(k) account) and the time of distribution (transferred out of the 401(k)). So the only part of your company stock that is subject to your ordinary income taxes is the value the stock was when it was first acquired by the 401(k) plan.
In sum, because of this NUA tax break, it may be most beneficial for you not to roll over your company stock from the 401(k) into an IRA. (However, the other assets in the 401(k) – such as mutual funds, etc. – do not receive the NUA tax break, so you would still likely want to roll these plan assets into an IRA and continue deferring taxes on past and future growth.)
Also, when you take advantage of the NUA tax break for your company stock (by not rolling it over into an IRA), you won't have to worry about taking required minimum distributions (RMD) on those assets since they are not part of an IRA.
To Sell or to Hold?
Say you sell the company stock shares immediately, instead of continuing to hold them in a regular brokerage account. For most stocks, when you sell them, you are required to have held them for at least one year to receive a lower capital gains tax rate on them, but this does not apply to the NUA. Therefore, you could sell the shares the day after you transferred them out of your 401(k) and pay only the lower current capital gains rate on the NUA. On the other hand, if you were to roll the stock into your IRA, you will eventually pay tax at a higher rate than your ordinary tax rate.
Say you decide to hold onto the stock from the 401(k) in your brokerage account. If the stocks appreciate further and you want to take advantage of the lower capital gains tax on that appreciation, you must hold the securities for more than one year before selling. Otherwise, any growth on the stock that occurred since the day it was moved out of the retirement plan will be taxed at your ordinary income tax rate. Future dividends are taxable at your ordinary income tax rate, too.
Benefits for Heirs
Beneficiaries to IRAs and other retirement plans must pay ordinary income taxes on all money they receive. The tax is based on your cost basis, which, for tax purposes, is generally zero since you haven't yet paid tax on the contributions. The zero-tax cost basis means that it cost you no taxes, so everything above that tax cost (which is zero) is profit and thus still taxable. In other words, a cost basis of zero for tax purposes means everything in the IRA is taxable for your beneficiaries. However, sometimes people will make after-tax contributions to an IRA plan. Those dollars would come out tax-free on a pro-rata basis.
However, inherited NUA stock is treated differently. Your heirs still inherit your cost basis in the stock, but when they cash in the NUA stock, they are entitled to the same treatment that you would have received (i.e., pay no ordinary income tax). But they must also abide by the same rules (i.e. if they hold the stock and the stock appreciates, to receive a lower capital gains rate on that appreciation, they must hold the stocks for a year). So when your heirs receive the inherited stock, they will pay only capital gains tax on the NUA.
If there was any appreciation between the date you distributed the stock from the 401(k) and the date you die, the value of the appreciation will receive a step-up in basis. This means that for tax purposes your beneficiaries receive the stock at the value it was on your date of death. So if they sell it for the same price it was when they inherited it, there is zero tax on that appreciation. It therefore passes to them income tax-free.
Doing the Tax-Savings Math
Let's go through an example to demonstrate these tax treatments.
Mike is 57, about to retire and has company stock in his 401(k) plan. The original cost of the stock was $200,000, but it is now worth $1 million. If he were to roll the $1 million over to his IRA, the money would grow tax-deferred until he took distributions. At that time, the distributions would be taxed as ordinary income. When Mike dies, his IRA beneficiaries will pay ordinary income tax on all of the money they receive.
But if Mike withdraws the stock from the plan rather than rolling it into his IRA, his tax situation would be different. He would have to pay ordinary income tax on the original cost of $200,000. However, the remaining $800,000 would not be subject to his ordinary income tax (because of the NUA tax break). If Mike immediately sold the stock, he would, on the NUA, have to pay only the lower capital gains tax. Say Mike holds that stock for a year. When he sells it, he pays the lower capital gains tax on the NUA and any additional appreciation. Finally, because the stock is not a part of an IRA, he does not have to worry about RMD.
Also, if Mike does not roll the stock into an IRA, his beneficiaries will also not have to pay ordinary income tax on the NUA. But they would not receive a step-up in basis for the NUA. This means they would have to pay (the lower) capital gains tax on the NUA. But if there is an appreciation between the date Mike distributed the stock from the 401(k), and the date of Mike's death, that appreciation will receive a step-up in basis. Thus, Mike's heirs won't have to pay income tax on that appreciation.
Let's summarize the difference between Mike not rolling his 401(k) assets into an IRA (taking advantage of the NUA tax break), and Mike rolling into an IRA. We'll assume that he is in the 35% tax bracket.
Here is the comparison if Mike immediately sells the stock:
Say Mike doesn't sell immediately and keeps the stock in the brokerage account. The value increases to $1.5 million in five years, and then he decides to sell.
|Not Rolling to an IRA||Rolling to IRA|
|Taxable amount||$1.3 million ($200,000 was already taxed upon transfer from 401(k))||$1.5 million|
|Tax rate||15% (lower capital gains tax)||35% (ordinary income tax)|
|Potential amount of tax Mike must pay||$195,000||$525,000|
|Plus amount of ordinary income tax previously paid||$70,000|
Finally, assume that Mike died in five years after the stock increases to $1.5 million. What would his beneficiaries have to pay?
|Inheriting from Regular Brokerage Account||Inheriting from an IRA|
|Taxable amount||$800,000||$1.5 million|
|Tax rate||15% (lower capital gains tax)||35% (ordinary income tax)|
|Amount receiving step-up in basis (the amount that is tax free)||$500,000 (the amount the stock appreciated since Mike distributed it from the 401(k)|
Precautions and Tips
The NUA tax break strictly applies to shares in the company you actually work for. (Other assets in the 401(k) – such as mutual funds – do not receive it.) And you should only consider taking advantage of it if the stock has appreciated significantly from the time it was purchased by your plan. If it has not, you would be better off rolling it over to your IRA and letting it continue to grow tax-deferred, as you would the mutual funds and other plan holdings.
You can, however, split up shares of stock. Suppose that some shares had a very low value when they were first contributed to your 401(k), while others did not. You could use the NUA on the cheaper shares and transfer the others to your IRA. Also remember that you will have to distribute and transfer your plan's assets as a lump sum. This means that all of the plan's assets, not just the employer's stock, must be removed within one calendar year. Therefore, since trustees can take several weeks to process such requests, make sure you give yourself enough time so that the distribution and transfer occur in the same year.
Another potential downside is that if you are not at least 55 and leaving your job, you will have to pay a 10% penalty on the taxable amount, which is the cost of the stock (not the full distribution value). However, that also means that if the stock has grown enough (the NUA is worth more than the original amount), it could be worthwhile to pay the penalty in order to capture the NUA benefit.
When you distribute from your employer's plan, the employer is required to withhold 20% from the distributions for the IRS, but you might be able to get around this. Have your employer transfer the non-stock assets directly to your IRA. Then have the stock distributed to you in kind. That way, there is nothing left in the plan for the IRS. But if you can't avoid the tax, make sure your employer withholds only 20% on the cost basis, not the entire amount.
Also, for record-keeping purposes, do not mix NUA stock with other company stock in the same brokerage account. Doing so could make it very difficult to get the tax break. Instead, set up a separate account to hold the NUA stock.
Other factors to determine before deciding not to roll the assets into an IRA are whether the shares make up a significant amount of your net worth, and whether your main goal is greater diversification. Remember, once the stock is out of the retirement plan, you will owe tax on any profits, albeit at a reduced rate. On the other hand, if you rolled it over to an IRA and sold shares, the tax is deferred. Furthermore, assets held in an IRA have greater creditor protection than non-IRA accounts.
Finally, in case your employer is not familiar with the NUA tax tactic, you may have to do some convincing. This might involve getting a competent financial advisor or accountant to intervene on your behalf.
The Bottom Line
To get the tax break that is available for company stock in a retirement plan, you'll have to spend some money upfront. And this may discourage some investors from using it. But when compared to the tax burden you or your heirs may face in the future, it could be money well spent.
(For further related reading, see "Moving Your Plan Assets?" and "Rollovers of After-Tax Assets May Change the Landscape of Your IRA.")