Here is a question that will probably stump most financial experts: Is there any kind of investment in a 401(k) plan that can qualify for long-term capital gains treatment -- a 20% tax rate -- instead of ordinary income when you take it out of the plan?
Surprisingly, yes! The answer: Your employer's stock.
If you elected to take company stock as an investment option, or the company matched your contribution with company stock, chances are you have accumulated a fair amount of your employer's stock. When you retire or change jobs, you can take the company stock as a distribution (instead of rolling it over into an IRA account), and possibly create a significant tax benefit.
Here's the rub: In taking the company stock as a distribution, you will only pay ordinary tax, which runs as high as 39.6%, on what you or the company paid for the stock (tax basis). Any tax on the growth on the stock, including when it was in the 401(k), is paid at the 20% capital gains rate when you sell it.
The key here is you don't roll this stock into an IRA. You simply opened a regular custodian account and transferred the stock to it, taking it as a distribution from the 401(k) plan.
Eric Fauth of
points out, "About 18% of the estimated $1.6 trillion now in 401(k) plans is invested in company stock." I've seen several employees with 50% or more of their 401(k) money in company stock. These are big numbers, so taking advantage of a relatively obscure part of the IRS tax code could be very important.
If you are changing jobs or retiring, you have the right to do something with your 401(k). Conventional wisdom says you have two options. The first: Roll over the distribution into an IRA (or into another employer retirement plan). This will defer all tax until you take a distribution. Then all the distributions will be taxed at your ordinary income tax rates. In many cases, this is good advice.
The second option: Take the distribution from the 401(k) as ordinary income. You will pay taxes at your ordinary rate on all the money. This is usually not the best way to go.
If those are the only two choices you know about, you would probably roll the money into an IRA. But, in taking your employer's stock or bonds as a distribution, you're given a third way.
The tax benefit is created on company stock that has grown in value. If that's the case, have your employer distribute the stock to you in a regular securities account. You would currently pay taxes only on the cost basis of the stock, not on what the stock is worth (market value). The difference between the cost basis and the fair market value of the employer securities at the time of distribution is called the Net Unrealized Appreciation, or NUA. For those of you that like code references, see IRC 402(e)(4)(E). You do not pay taxes on the Net Unrealized Appreciation until you sell the employer securities. It is then taxed as long-term capital gains (20%). For most people that is less than their ordinary rate.
Let's look at an example that shows the 401(k) money invested in mutual funds and company stock. The example compares two situations involving $800,000 in a 401(k):
Roll over only the $408,000 in mutual funds into an IRA. The total amount of company stock, $392,000, is taken as a distribution. Ordinary income tax is paid on the tax basis of $92,000, the amount the company has contributed in its stock. There is no current tax on the NUA of $300,000. The income tax of $33,120 on the tax basis is paid currently. That leaves a total balance of $358,000 in the stock.
Roll over the entire $800,000 in an IRA.
Additional assumptions: Cost price of ABC stock is $23; current price of ABC stock is $98; total shares held: 4,000; income tax rate is 36%; capital gains rate is 20%; assumed earnings rate for IRA and stock is 10%; everything is held for 10 years; the employee is over age 59 1/2, so there is no premature withdrawal penalty on the company stock.
A tax savings of $165,141 is pretty impressive, but the tax issue is not the only thing to consider in this kind of situation. It is probably not a good idea to have such a high percentage of one stock in a portfolio. Just ask the people at
Proctor & Gamble
Have a great week.
Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at