Many workers own stock in their employer's publicly-traded company. Usually it happens that a retirement plan i.e. 401(k) holds these securities, and at the time of retirement it is rolled over to an IRA because it seems to be the only alternative to them. The IRS, however, gives you another choice that could save you thousands of dollars when it's time to retire and make your 401k withdrawals.
When you make a 401k withdrawal, income tax will be assessed on your money at the same tax rate as your regular income. To avoid that tax, most people perform a 401k rollover to an IRA. However, the asset that should often not be included in that rollover is the shares of company stock in the 401k because IRS provides a special tax break. Specifically, IRA permits that the appreciation on those shares since they were purchased (called net unrealized appreciation or NUA), may be taxed at capital gains rates (currently a maximum of 15%) rather than as ordinary income.
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 don't 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 ordinary income. Consider the following example for clarity.
Within your 401k, you accumulated shares in the stock of your employer over time at an average cost of $10. It is now time to retire and the shares have a value of $70. You have the following choices:
- rollover the shares to an IRA and eventually when you withdraw them or their value, pay ordinary income tax (as high as 35% currently) on the entire value OR
- do not rollover the shares, pay ordinary income tax now on the $10 but eventually, when you sell the shares, pay only capital gains tax on any appreciation
Most people prefer option 2 if they have significant appreciation on the shares. Just after completing the 401k withdrawal of your securities to an ordinary brokerage account, the remaining amount of your plan's asset can be rolled over to an IRA for continued tax free growth.
If you desire, you can sell the employers shares immediately after you complete your 401k withdrawal and enjoy the capital gains rate on the appreciation. The additional bonus from IRS is that the standard holding period of one year for gains to qualify for capital gains rates is not applicable to NUA. Should the shares appreciate further in your possession (beyond the $70 as per our above example), you have to hold the securities for more than a year to enjoy the the capital gains rate on that further appreciation.
One additional benefit is that because the shares are not part of your IRA, there is no required minimum distribution at age 70 1/2. You can keep the shares indefinitely if you choose.
Your heirs will also be grateful to you. Normal income taxes have to be paid by the recipients who inherit IRA's. If they inherit the employer shares, which are not part of your IRA, the heirs also get a tax advantage. They get the same capital gains treatment on the NUA (the difference between the $70 and $10) to which you were entitled. They then enjoy the step-up-in-basis advantage for any appreciation beyond the $70.
Check to see if you have any employer's shares before rolling over your 401k into an IRA and potentially save tax with the NUA provision.
1 - IRS Reg. 1.402(a)-1(b), (e)(4)(B), (e)(4)(D)
2 - IRS Notice 98-24, http://www.irs.gov/pub/irs-drop/not98-24.pdf
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