Rolling an old 401(k) into an individual retirement account (IRA) or a new 401(k) may seem like a good move when you change jobs or retire, but you should think twice if that 401(k) plan includes company stock.
Rushing to sell a company’s stock can wipe out a valuable tax break. Here’s what you need to know.
Why company stock in a 401(k) is different
First, you must understand net unrealized appreciation (NUA): the difference between what the stock was paid for, also called the cost basis, and its current market value. For example, if you received $100 in a company’s stock that grew to $180, the NUA is $80.
Traditional 401(k) withdrawals are often taxed as ordinary income upon withdrawal. The same rule applies to traditional IRAs, so some people may think that rolling more than a 401(k) into an IRA has no effect on how much tax they end up paying. Company stocks are different in that they cannot receive special tax treatment.
When you transfer company stock to a taxable corporation, you only pay income tax on the cost basis, not on the capitalized value. Then when you sell that asset later, you’ll pay long-term capital gains tax on the NUA (plus capital gains after moving the money into a taxable brokerage account). Capital gains tax rates are generally lower than income tax rates.
When you move company stock from a company 401(k) to an IRA, your shares lose their NUA status. After that, all those capital gains will be treated as ordinary income.
When NUA can hit an obvious IRA rollover
NUA may have reasonable tax benefits for people in higher tax brackets. Fidelity also says the strategy can be especially useful during income gap years, especially before Social Security and retirement income start.
However, the NUA rule only applies if you distribute the entire balance of that eligible employer’s retirement plan within one tax year. You must completely stock the 401(k) with company stock, including assets that are not company stock, to get the NUA tax benefit. It is often recommended that you take this lump sum if you are not collecting retirement income.
The company’s stock must be distributed according to assets in a taxable brokerage account as part of the distribution of qualified capital.
Dangers, rules and mistakes to avoid
Tax breaks often come with exchanges, and NUA is no different. A large company stock position doesn’t give you the ability to change your portfolio, and if the company’s stock drops too much, your retirement plan could be disrupted.
Skipping company shares in an IRA will discard the NUA opportunity. Retirees should evaluate how much of their portfolio contains company stock and what their current and future tax brackets will look like.
A tax professional or financial advisor can help you make the right choice for your situation. Retirees must consider taxes, timing and investment risk when planning their retirement.
