Do you hold your employer's stock in your 401(k) plan? Whether you bought it for the plan or you received it as part of the company's matching contribution, you'll be faced with an important decision when you leave the company.
The simplest choice may be to roll over your entire 401(k) balance into an Individual Retirement Account. But that might not be the smartest choice. If you hold company stock, you may be giving up a big tax break if you don't take advantage of the so-called net unrealized appreciation, or NUA, strategy.
NUA refers to the increase in your company stock's value since its purchase. Under federal tax rules, when you sell the stock, your gain could be taxed at the long-term capital gains rate, which in 2014 is a maximum 20%, rather than at your income-tax rate, which could be as high as 39.6%.
Here's how it might work: Let's say the company stock in your 401(k) was worth a $100,000 when it was purchased. Now, after many years, you're leaving the company and the stock is worth $1 million, for a hypothetical net unrealized appreciation of $900,000.
If you rolled that stock over into an IRA, you would eventually owe income taxes, and possibly tax penalties, whenever you started taking withdrawals. In our example, that might mean paying $396,000 in federal taxes, assuming you were in that top 39.6% federal tax bracket and assuming the account's value remained at $1 million. Result: You would be left with $604,000.
What's the alternative? You could set up a regular taxable account and direct your 401(k) administrator to move the company stock into that account, while the rest of your 401(k) balance is rolled into your IRA. You would immediately have to pay federal income taxes, and possibly tax penalties, on the stock's $100,000 cost basis. That would mean losing $39,600 to Uncle Sam (and possibly more if you have to pay tax penalties), again assuming you're in that 39.6% federal tax bracket.
But the capital-gains taxes on the $900,000, as well as the tax on any subsequent investment growth, wouldn't come due until you sell the shares. If you sold the stock immediately, you would pay taxes at the long-term capital-gains rate on the appreciation that occurred within the 401(k) plan. Assuming the shares were still worth $1 million, you would lose $180,000 to taxes at 2013's maximum 20% long-term capital-gains rate. Add that $180,000 to the $39,600 you earlier paid, and your total tax bill would be $219,600. That's far less than the $396,000 you would have paid if you'd simply rolled everything into an IRA.
One wrinkle: To pay tax at the long-term capital-gains rate on any appreciation that occurred after you pulled the stock out of the 401(k) plan, you would have to hold the shares for at least a year after receiving the shares from the plan. In other words, if the stock's value had grown from $1 million to $1.1 million since you had pulled the stock out of the 401(k), the $100,000 of additional growth would be taxed at ordinary income-tax rates if you sold within the first year.
Because the company stock won't be in an IRA, you don't have to take required minimum distributions once you turn age 70½. Instead, you could hang on to the shares for as long as you like. Still, selling your company stock could be a prudent move, especially if the stock represents a significant portion of your wealth.
The NUA strategy is not for everyone. For example, if you are fairly young when you change jobs, the stock may not have appreciated enough to make this tactic worthwhile, especially given the income taxes and possible tax penalties that you'll have to pay right away on the stock's purchase price.
Finally, keep in mind that this discussion only applies to federal taxes. State and local tax rules may be different. Also, if you bequeath NUA stock to your heirs, they won't fully benefit from the usual step-up in basis. Indeed, because the tax rules are complicated, you should seriously consider consulting a tax professional.
Citigroup Inc. and its affiliates do not provide tax or legal advice. To the extent that this material or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.
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