Many workers own shares of employer stock through 401(k) or other retirement plans. Few of these workers, or even their financial advisers, know the tax break that is available to substantially reduce the tax burden from selling those shares. With a little planning and by following a few steps, workers can substantially reduce the tax burden on selling the employer stock and increase their after-tax retirement funds.
The tax break is known as net unrealized appreciation or NUA. The rules work 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 at ordinary income rates.
To maximize tax breaks, you do not want to sell employer stock while it is in your 401(k). 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. Otherwise, the shrewd tax strategy is to hold the employer stock while it is in the retirement account.
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. If you do, you are ineligible for the tax break.
That is what not to do. Here is what to do when you retire or otherwise leave the employer to grab the tax break.
Take a lump sum distribution from the 401(k) plan. This means that all of the account must be withdrawn from the account in the same calendar year. The rule is firm. The entire account must be withdrawn within the same year. It does not have to be distributed at once, but the full account must be distributed within the same tax year.
Have the employer stock deposited in a taxable brokerage account in your name. It usually is best to have the other assets rolled over to an IRA. The IRA rollover means that those assets are not taxed until withdrawn from the IRA.
If you follow these rules, the employer stock receives special tax treatment. You include in gross income in the year of the lump sum distribution 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. The long-term gain treatment is allowed regardless of how long the shares have been owned either inside or outside of the 401(k).
The treatment is the same whether you purchased the shares through your 401(k) plan or received them as a matching contribution from the employer.
Suppose you treat the employer stock the same as your other IRA assets and roll it over to the IRA or keep it in the 401(k) until it is distributed to you. Then, the value of the stock is taxed as ordinary income when distributed the same as your other IRA or 401(k) assets.
The tax break is available even if the company’s stock is not publicly-traded. Many private companies periodically determine a value for their stock. These values can be used to determine the employee’s basis in the stock. When the employer stock is distributed to you, the employer should tell you its basis.
The NUA treatment also is available to heirs who inherit the 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.
An employee does not have to use the NUA treatment for all the stock in the plan. Shares that have appreciated a lot can be distributed to the brokerage account and taxes on only the basis paid today. 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 are distributed.
If a person holds the shares until death, the heirs do not get to 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. If the employee is at least age 55 and takes the distribution after separating from the employer, the 10% penalty usually does not apply. November 2007.