Getting the Most From Your Employer's Stock

Company stock has made many employees rich on paper, but it can also extract a painful tax hit. When you retire, you'll have to make some weighty financial decisions about what to do with the employer stocks or bonds you hold in your 401(k), profit-sharing plan or stock bonus plan.

If you find yourself in this situation, you should be aware of a unique benefit, known as the net unrealized appreciation (NUA) rule, that could save you money on taxes. NUA refers to the net unrealized appreciation on company stock, and the rule reduces how much you'll be taxed on that appreciation.

But it applies only to company stock. It won't work for mutual funds or securities you own in other companies.

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How the NUA Works

In practice, electing the NUA option means you deposit a lump sum of your employer's stock into a taxable brokerage account when you retire. Here's the bottom line, taxwise: You pay ordinary income tax on the original cost of your company stock. Let's hope the stock has gained in value since it was purchased, but you don't have to pay taxes on that appreciated portion right now.

In fact, you won't have to pay any taxes on the appreciation until you sell it -- and at that point, you pay taxes at only the long-term capital gains rate of 20%.

Think of it this way: With the NUA option, you agree to pay a portion of taxes upfront, with the aim of paying lower taxes later (the long-term capital gains rate, instead of your income tax rate).

The more your company stock has appreciated, the more you save on taxes by using the NUA rule. Say your company stock is worth $1 million. The shares originally cost only $300,000, so you have a hefty $700,000 of net unrealized appreciation. But because you elected the NUA option, you'll pay income tax only on that $300,000. The other $700,000 goes into a brokerage account. When you sell it, you'll get to pay the 20% long-term capital gains rate instead of your income tax rate.

Also worth noting: If you want to leave a bequest, the NUA election is a better deal for your heirs than rolling your stock into an IRA (more on that option below). That's because if your heirs inherit money through an IRA, they have to pay income taxes on it. But if they inherit stock though NUA, they pay tax at the more favorable long-term capital gains rate.

But be aware that unlike many assets, money inherited through NUA does not receive a step-up in basis at the time of the owner's death. (With a step-up in basis, an heir is only taxed on how much an asset has appreciated since its value at the time of the owner's death). "Your heirs will still have to pay the capital gains tax when they sell it," points out George H. Coughlin II, a certified financial planner in Walnut Creek, Calif., and founder of IRAplanning.com, which provides information on IRA distributions and retirement plans.

Consider the Rollover Option

But there's a disadvantage to the NUA: the upfront costs of paying income taxes. You might have to sell some of your stock to cover the tax hit, thus reducing the sum invested. Or maybe you've got the money for taxes, but would rather spend it on something fun.

If that's the case, you could choose option two: rolling over your entire distribution of company stock into an IRA. If you do this, you get to defer all taxes until you start taking distributions, which you're required to do a year after you reach age 70¿. The upside is that you're not taxed now. The downside is that when you start withdrawing money from your IRA, you'll be taxed at an ordinary income rate, not at the favorable long-term capital gains rate.

Still, this option is popular because it doesn't incur any taxes upfront. "Most of the time, we do just an IRA rollover of this lump sum so we can sell it right away," says Coughlin. "We can ignore the taxes, at least temporarily, because it's still tax-deferred in the IRA. Therefore, we have 100 pennies on the dollar we can use to reinvest for diversification purposes."

Finally, note that there's a third option: doing nothing. You could simply leave your employer stock in the company plan. If you choose to do this, you'll pay ordinary income tax on withdrawals, as you would with an IRA. The disadvantage of staying put is that, if you decide to diversify out of your stock, the investment alternatives are limited to what's offered by your company.

Which Is the Best Option?

All this said, how do you decide which option is best for you? "It's very situation-specific. It's really a good idea to run the numbers and play with assumptions before you make a decision," says Karen Goodfriend, a CPA/personal financial specialist at GoldsteinEnright Financial Advisers in Menlo Park, Calif.

Among the factors to consider are whether you can afford to pay tax upfront if you elect NUA. Has your employer's stock appreciated much from its original cost? If so, the tax benefit you'd receive through NUA would be valuable. And consider what tax bracket you're likely to be in at the time you need to make withdrawals. After retirement, many people drop into lower income tax brackets. As a result, they'd stand to benefit less from applying the NUA rule.

Finally, take care not to let the tax benefits of your NUA take precedence over a bigger investment concern: the need to diversify. If you plan to retire in a year or two, you may be tempted to keep a relatively large portion of your assets in company stock, hoping to take advantage of NUA. (Remember, you can't receive this tax benefit if you're invested in noncompany stock or mutual funds.)

But if your company stock takes a dive before you retire and you haven't diversified into other investments, you could get walloped.

"If somebody can afford to take a risk [by keeping a big portion of assets in company stock], that's one thing. But if you're basing your retirement nest egg on the value of that stock, it can be a risky thing to plan that course of action off in the future," says Goodfriend. "People can get into trouble when they think about saving taxes, but take risk in the meantime."

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