Many workers own stock in their employer's publicly-traded company. Frequently this stock is held in a retirement plan, such as a 401(k) plan, and rolled into an IRA when people retire because they think that this is their only option. But the IRS gives you another option that can help you save a lot of money when retiring and making your 401k rollover. Because many people leave employment prior to age 59 1/2, we will assume this is a 401k early withdrawal and account for the 10% IRA penalty (withdrawals prior to age 59 1/2 are deemed early 401k withdrawals and IRA penalizes them as an inducement not to take withdrawals prior to an assumed retirement age).
You might puzzle about the title of this post, "positives of your 401k early withdrawal" if in fact you will be penalized. But we have an offsetting benefit in mind. That benefit accrues to those who have employer shares inside their 401(k) account. As an example, assume you work for IBM and part of your 401(k) account is invested in IBM shares. When you leave IBM and proceed to roll over your 401(k) account to your own IRA, there is a very significant benefit available on those IBM shares. The benefit is a preferential income tax that far offsets the 10% penalty because you're under age 59 1/2 taking an early 401(k) withdrawal. This preferential lower income tax is labeled "net unrealized appreciation" or NUA.
The NUA is the difference in the value of the stock at the time of its purchase in the 401k and the time of its withdrawal from the 401k plan. If you do not roll over the shares to an IRA at the time of withdrawal, contrary to the norm, your cost of the shares will be taxable as the normal income when the plan had attained it. Why would you want to pay income tax now on the purchase price of the shares? Because later, when you go to sell the shares, the gains will be taxed at the capital gains rate (currently a maximum of 15% compared to a maximum of 35% on your other income).
Just after completing the 401k early withdrawal of your securities to an ordinary brokerage account, the remaining amount of your plan's asset can be rolled over to an IRA. This will ensure continuous accumulation on these tax-deferred funds. Because we assume this is an early 401(k) withdrawal, it will be subject to the IRS 10% penalty. However, the penalty only applies to the original cost of the shares that you are not rolling over to an IRA. The question then becomes, does the later tax savings provided by the NUA rules, the fact that you will pay only capital gains rates on the gain when the shares are sold, offset the penalty you need to pay today to take advantage of the NUA rules?
The table below provides an illustration. Simply look at the bottom row of each table and you will see that even with the penalty, the savings from the NUA rules are so substantial, they far offset the 401k early withdrawal 10% penalty. Of course, the illustration may not coincide your your numbers but it provides a guide and you can recalculate the same for your figures.
Using the NUA tax break gives you another great money-saving benefit. You will not have any troublesome IRA RMD on the securities due to the fact that they is not an element of your IRA. After your age is 70½ years, the IRS won't be able to make you sell and pay taxes at ordinary rates.
Your loved ones will thank you too. When beneficiaries inherit IRAs, they must pay ordinary income tax on all funds. However, inherited NUA securities obtain a superior proposition. Due to the reason that you fittingly chose to exercise the NUA rule, your successors will benefit the same as you and only pay capital gains rate as you would have.
So before you roll over your 401k into an IRA, as most people blindly do, check to see if you have shares of your employer's stock as an IRA asset. If so, taking those shares as a 401k early withdrawal and benefiting by an IRA tax break could save you a lot of cash in the long run.
Assumptions for table below:
a. original cost of shares $200,000
b. value of shares at time of early 401k withdrawal $1 million
|With NUA||Without NUA|
|35% Tax on $200,000||$70,000||35% Tax on $1 million||$350,000|
|15% Tax on $800,000||$120,000|
Let's assume the value of shares increases to $1.5 million in five years, and you decide to sell:
|With NUA||Without NUA|
|Taxable Amount||$1.3 million||$1.5 million|
|Potential Income Tax to Jackie||$195,000|
|Plus Amount Previously Paid||$90,000 (incl penalty)|
Lose a Fortune on Your 401k Rollover
If you do not do any of these correctly:
- Opt for a distribution rather than direct transfer
- Rollover company stock to an IRA
- Choose to rollover to a Roth IRA
- Rollover to your new employer’s 401k
- Rollover post-tax contributions