Company Stock in a 401(k)? The Tax Break That Can Beat a Plain IRA Rollover
Rolling an old 401(k) into an individual retirement account (IRA) or a new 401(k) may seem like a good move when you are switching jobs or retiring, but you should think twice if that 401(k) plan includes company stock.
Rushing to roll over company stock can wipe out a valuable tax break. Here's what you should know.
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Why company stock in a 401(k) is different
First, you should understand net unrealized appreciation (NUA): the difference between what was paid for the stock, also called the cost basis, and its current market value. For instance, if you received $100 in company stock that grew to $180, the NUA is $80.
Traditional 401(k) withdrawals are generally taxed as ordinary income the moment you withdraw. The same rule applies to traditional IRAs, so some people may think that rolling over 401(k) funds to an IRA doesn’t have any impact on how much tax they end up paying. Company stocks are an exception since they can qualify for a special tax treatment.
When you transfer company stock to a taxable brokerage, you only pay income tax on the cost basis, not on the amount it’s grown. Then when you sell the asset later, you’ll pay long-term capital gains tax on the NUA (plus capital gains from after you moved the money into the taxable brokerage account). The capital gains tax rates are often lower than the income tax rates.
If you move company stock from the company’s 401(k) to an IRA, your shares lose their NUA status. Then, all of those capital gains will be treated as ordinary income.
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When NUA can beat a plain IRA rollover
NUA can potentially have meaningful tax advantages for people who are in high tax brackets. Fidelity also says the strategy can be especially useful during income gap years, especially before Social Security and pension income start.
However, the NUA rule only applies if you distribute the entire balance of that employer's qualified retirement plan within a single tax year. You must completely empty the 401(k) with the company shares, including assets that aren’t company shares, to get the NUA tax advantage. It’s often recommended that you take out this lump-sum distribution when you aren’t collecting retirement income.
Company stock must be distributed in-kind to a taxable brokerage account as part of a qualifying lump-sum distribution.
The risks, rules and mistakes to avoid
Tax breaks often come with trade-offs, and NUA is no different. A large company stock position doesn’t give you the ability to diversify your portfolio, and if the company’s stock goes down significantly, your retirement plan could suffer.
Rolling over the company shares into an IRA will forfeit the NUA opportunity. Retirees should assess how much of their portfolio consists of company stock and what their current and future tax brackets will look like.
A tax professional or a financial advisor can help you make the right choice for your situation. Retirees should consider taxes, timing and investment risk when crafting their retirement plan.