Holding Employer Stocks in 401(k)s

Employees who own company stock or other securities in their retirement plans should review their options. The American Taxpayer Relief Act of 2012 might have changed which is the best strategy for distributing the stock from the account.

Many workers own shares of employer stock or other securities through 401(k) or other retirement plans. Few of these workers, or even their financial advisers, know the tax break available to substantially reduce the tax burden from selling those shares. By following a few steps, workers can reduce substantially the taxes from selling the employer stock. The tax break has been available for years, and the latest tax law didn’t change the details. But because it changed tax rates, the law’s effects should cause a review of strategies.

The tax break is known as net unrealized appreciation or NUA. It works like this.

If you sell the employer stock while it is in your 401(k) or other retirement account, you do not get the tax break. The proceeds from that sale eventually will be distributed to you (from either the 401(k) or an IRA rollover) and be taxed as ordinary income.

When you retire or otherwise leave the employer and the account still owns the employer stock, however, you have a choice. You can treat the stock the same as other assets, keeping it in the 401(k) or rolling it to an IRA. As distributions of the stock or its sale proceeds are made, they are taxed as ordinary income.

The other option is to follow the NUA procedure. You distribute the stock to a taxable brokerage account and include in gross income in the year of the distribution only the original value or cost basis of the shares. No other taxes are due at that time, no matter how much the shares appreciated since you acquired them.

As you sell the employer shares, long-term capital gains taxes are due on the appreciation that occurred since you acquired the shares. Long-term gain treatment is allowed regardless of how long the shares have been owned either inside or outside of the 401(k).

To receive the NUA treatment, you have to take a lump sum distribution from the 401(k) plan. This means that all of the assets must be withdrawn from the account in the same calendar year. The rule is firm. The full account must be distributed within the same year. As part of the distribution, have the employer stock deposited in a taxable brokerage account in your name. The rest of the account can be rolled over to an IRA or treated however else you want. The NUA doesn’t change the tax treatment of or options for other assets.

The treatment of the employer stock under this procedure is the same whether you purchased the shares through your 401(k) plan or received them as a matching contribution from the employer.

The NUA tax break is available even if the company’s stock is not publicly-traded. Many private companies regularly determine a value for their stock. These values can be used to determine your basis in the stock. When the stock is distributed to you, the employer should tell you its basis.

The NUA treatment also is available to heirs who inherit a 401(k) account and take a lump sum distribution after the employee’s death. It also is available to divorced spouses if they received part of the retirement account under a qualified domestic relations order.

You don’t have to use the NUA treatment for all the stock in the plan. For example, shares that have appreciated a lot can be distributed to the brokerage account and taxes paid today on only the basis. Shares that have not appreciated much can be rolled over to an IRA with other account assets; taxes on those shares are deferred until the shares or share proceeds are distributed.

If a person holds the shares until death, the heirs do not increase the tax basis of the shares. The heirs will owe capital gains on the appreciation when they sell the shares just as the employee would have.

The 10% early distribution penalty applies to distributions of employer shares taken as part of an NUA distribution. But if the employee is at least age 55 and takes the distribution after separating from the employer, the 10% penalty usually does not apply.

To qualify for the tax break, you also cannot take any withdrawals from the retirement plan before taking a distribution of the stock, even required minimum distributions after age 70½.

Keep in mind, there might be non-tax reasons for selling the stock. If you have doubts about the long-term future for the stock or believe too much of your net worth is in the stock, you might want to sell some or all of it.

Before the new law, when there weren’t non-tax reasons to sell, the NUA option almost always was the shrewd tax strategy.

For many people, the traditional strategy still is best. For some others, at a minimum the strategy isn’t as beneficial as before. The top ordinary income tax rate is increased to 39.6% from 35%. But the top long-term capital gains rate also is increased to 20% from 15%. In addition, for some people there is the additional 3.8% tax on net investment income, which includes sales of employer stock (see page five of this visit). So, the maximum tax on selling the shares from a brokerage account increased to 23.8% from 15%.

As I said, for most people NUA treatment still is the best deal. For others, there’s less of an advantage of jumping through the hoops for NUA treatment. Still other people will find NUA treatment beneficial but will have to carefully plan future sales of the stock to avoid triggering the 3.8% investment income tax or pushing themselves from the 15% long-term capital gains bracket to the top 20% rate.

RW June 2013.