401(k) plans are a great way to save money for retirement, but you have to manage it well! You are responsible for selecting investments and you will ultimately bear the brunt of your choices. Its critical you get it right! Many employers will put ‘guiderails’ on the plan by limiting investment choices to a selection of pre-scrubbed and often times generic mutual funds. These are dull but otherwise fine.
When an employer offers the option of buying company stock in an otherwise stodgy 401k plan, it can be especially tempting! Owning it isn’t an issue – your company might make a great investment. But owning the stock in your 401k does come with some unique tax opportunities and risks to be aware of.
Too much of a good thing
A 401(k) plan is a retirement vehicle. It’s filled with money that absolutely, positively must be there in another 20 years. Its not the place to day trade or pick lottery stocks. Even still, you could start small and get lucky.
Consider the case of Microsoft (MSFT). Say you bought shares in your 401(k) five years ago as a loyal employee when it was trading around $60/share. You kept your purchase to just 5% of your total 401(k) value. The company is up about 440% over the last five years. The S&P is up ‘just’ a little over 100%. If you didn’t rebalance, your shares of Microsoft may be as much as 20% of your total portfolio (or a little over 4x what a US large cap fund would have returned).
You lucked out on a great stock pick! Should you sell?
Selling vs. Holding
The short answer is probably. This isn’t the kind of account where you want to bet the farm. Diversity is key. Financial planners disagree on precisely how much is too much, but a good rule of thumb is not to keep more than 10% of your total portfolio in any single company. Doing so exposes you to idiosyncratic sector risks and single company risks – virtually all of which are out of your control and nearly impossible to predict. To frame this even further, regulators can’t prevent you from loading up. It’s your account and you can do what you want. But they can, and do, regulate pension fund managers and prohibit them from holding more than 10% of plan assets in company stock.
You can buy and sell in your 401(k) without tax consequence. This makes it a great place to execute a sale, but consider your picture fully. You may decide its worthwhile to hold the stock in your Roth 401(k) with your company being in full growth mode while you trim it from your IRA instead. The situation is the boss.
Taking advantage of the tax code
Company stock in your 401(k) comes with a special tax provision known as Net Unrealized Appreciation (NUA). You have the ability to roll the stock out of the plan and receive favorable capital gains treatment instead of the typical ordinary income tax treatment on the gain. It’s a good deal, since the current maximum long-term capital gains tax treatment is 20% vs. the top ordinary income tax rate of 37%.
It gets a little bit sweeter. The NUA is always taxed at long-term capital gains rates per IRS Notice 98-24 regardless of how long you’ve actually owned the stock! This is great if you have stock in a hyper-growth company notching impressive annual gains.
But you need hit a triggering event to qualify for the tax treatment. The triggers are death (not recommended), disability, separation from service, or reaching age 59.5. Retirement is the most common trigger, but you can complete an NUA transaction if your employer allows for in-service distributions following attainment of age 59.5.
In addition to the triggers, the entire account balance must be moved from the 401k and the employer stock must be distributed in-kind. In-kind means that the stock moves as is. It isn’t sold and repurchased. Its simply picked up from account A and dropped in account B unchanged.
Tax treatment at the point of sale
The cost basis of your employer stock is taxed at ordinary income rates the moment you distribute the stock. The Net Unrealized Appreciation (the difference between your basis and the market value) is taxed at long-term capital gains rates as noted above. But the NUA isn’t realized until those shares are actually sold! This tends to be the case in most situations as people generally look to diversify their holdings, but you can roll out shares and hang on to them indefinitely.
If the shares are held past the 401k distribution, any further appreciation is subject to the normal rules for capital gains. This means you see short term gains when held after distribution but still sold within the space of a year and long-term gains when sold after a year. You’ll simply reduce the amount of NUA recognized on the distribution if the share price dips following distribution, though if it dips WAY down below your original basis you’ll just claim a capital loss.
Notably, the NUA isn’t subject to the 3.8% Medicare surtax on net investment income (treasury regulation 1.411-8(b)(4)(ii)). This means the capital gain on the NUA is simply 0%, 15%, or 20% depending on your tax bracket.
The mechanics of rolling it out
The entire account balance must be rolled out to qualify for NUA treatment, but it doesn’t all have to go to the same place! You can process the distribution with your employer stock moving to a taxable brokerage account qualifying for NUA treatment while the remainder of your account heads to your IRA as part of a non-taxable rollover. Moreover, the 20% withholding that typically applies to 401(k) distributions made payable to you is waived for employer stock (IRS Publication 575: Pension and Annuity Income). Without this, NUA transactions would effectively be treated the same as an indirect rollover for tax purposes.
You can get even more granular. Treasury Regulation 1.402(a)-1(b)(2)(ii)(A) allows you to specify which lots to sell.
For example, say Bill bought company stock in year one for $60/share and again in year three for $200/share. The current stock price is $240/share. Bill can elect to roll out just the shares with a $60 basis while rolling over the $200 basis shares to his IRA (because all money must leave the 401(k) to qualify for NUA treatment)! Bill pays ordinary income tax on the basis of the shares he moves to his taxable brokerage account while the gain ($240 – $60 = $180/share) qualifies for preferential capital gains treatment!
Why not roll all of it? Because NUA treatment is most effective on low-basis shares. You’re trading long-term tax deferral for lower capital gains tax rates. Forfeiting the deferral is only worthwhile when the embedded gains are large enough provide a current benefit outweighing the long-term deferral benefit.
Timing it right
There is no time limit on when you have to move employer stock in order to qualify for NUA treatment. However, you must complete a full lump sum distribution or you will forfeit the opportunity to claim the NUA tax treatment. You’ll have to wait for another triggering event before the opportunity comes up in this case.
Consider Abby, who retires at 57 and separates from service. She takes $20,000 from her 401(k) to fund a vacation celebrating the occasion. She has until the end of the tax year to complete a full distribution of the remaining balance of her 401(k) or she’ll lose the ability to claim NUA treatment.
But Abby doesn’t do this. She leaves it as a partial distribution only. She’ll now have to wait for another triggering event, which comes up next when she hits age 59.5.
She decides not to touch her 401(k) when she does reach age 59.5. Instead, she picks up some part time work to keep busy and help with her bills. The money stays in her old employer’s 401(k) until she its age 72, when she receives her first required minimum distribution. Now she must complete a full distribution before the end of the year if she wants to qualify for NUA treatment!
Managing old accounts and early withdrawals
Since the NUA rules are governed by triggering events and not hard timelines, it’s possible to accumulate several old 401(k) plans that are all eligible for NUA treatment. This of course requires you to have worked for a company with staying power that spans decades, but it’s possible.
As a matter of form and function you may prefer to consolidate retirement accounts as you move from employer to employer. This puts the NUA treatment in a use it or lose it status. If you do use it and do so before age 59.5, you will be subject to the 10% early withdrawal penalty but only on the basis of the shares rolled over!
But, you can avoid the early withdrawal penalty by waiting to age 59.5 or qualifying for an exception. Abby in the example above retired at 57. The age 55 early withdrawal exception allows her to pull funds from her most recent employer’s 401k plan while avoiding the early withdrawal penalty if she is at least age 55 and retired. The makes any NUA election for the rolled over employer stock and the vacation withdrawal she made penalty-free transactions, though both are still taxable transactions.
Despite this, it may still be worthwhile to take the early withdrawal penalty if the basis is low enough. Think of Barry, who is 52 and has employer stock worth $750,000 on basis of just $35,000. The 10% penalty will only be assessed on the $35,000, which is a grand total of $3,500. This is only 0.5% of the total value of the stock – a cost that Barry will probably find worthwhile to get full access to and capital gains treatment on $715,000 of employer stock!
NUA tax treatment is most effective when you have employer stock with a large, embedded gain. For those who have been with their employer for decades and have many different lots of employer stock, isolating the earliest shares (likely to have the lowest basis) for NUA treatment while selling the others in the 401k for the sake of keeping a balanced and diversified portfolio may be the most viable option.
For those that do roll out shares, the tax impact of the distribution may force you to sell other investments to cover a tax bill. This is a nonstarter for some, particularly if you’re retiring before age 65 and need a low income to qualify for ACA subsidies on a marketplace health plan! The tax bill can be covered with a margin loan that is extinguished later (at favorable capital gains rates) when you do ultimately sell those appreciated company shares.
When you do sell, splitting between tax years is recommended. This is especially true for those who fully retire and qualify for the 0% capital gains tax bracket. A short-term put can even be used to hedge the risk of the share price tumbling during the intervening period.
The bottom line is this: your shares of company stock are an asset with opportunities for good (lower taxes) and bad (heavy overconcentration). You must walk the dividing line between the two and devise a strategy that works. And if you can’t do it you should call an expert (like us) to help you figure it out!