By Phil Goldsmith of LWBJ
Employees separating from service with their employer may realize a tax benefit if they hold employer stock or securities within their company 401(k) plan. A little-known rule within the tax code allows the Net Unrealized Appreciation (NUA) within the employer stock to be distributed without being subject to immediate taxation.
The rule allows an individual to convert what would otherwise be ordinary income upon distribution into long-term capital gain. In addition, any future appreciation will be capital gain and taxed at favorable long-term rates, if the stock is held for more than one year after distribution. The cost basis of the stock will be taxed at ordinary income rates upon distribution and may be subject to the 10% early withdrawal penalty if no exception applies.
An example highlights the tax savings which may be available:
Employee retires at age 60 holding employer stock valued at $300,000 with a cost basis of $50,000 in the company’s 401(k) plan. Employee is in the 39.6% ordinary tax bracket and 20% long-term capital gains bracket. If the employee took a lump sum distribution of the employer stock upon retirement, they would owe $19,800 ($50,000 x 39.6%) in current tax on the $50,000 cost basis of the distribution. Assuming an 8% return and payment of the current tax with other dollars, the employer stock would grow to $647,677 after 10 years. If they sold the stock at that time, they would have a basis of $50,000 (the previously taxed amount) and gain of $597,677. The capital gains tax upon sale would be $119,535 for a total tax paid of $139,335. Alternatively, if Employee kept the stock in the company 401(k) plan or rolled it into an IRA, the distribution of $647,677 would be subject to federal tax of $256,480. By taking advantage of the NUA, Employee saved $137,145 in tax.
This rule only applies to employer stock and securities held in the company 401(k) plan. For the distribution to qualify, it must be made upon either separation from service, attaining age 59½, total disability or death. The employee must take a distribution of their entire 401(k) balance, including non-employer stock investments, within the same taxable year. The non-employer stock investments may be rolled over into an IRA in a tax-free transaction.
Please contact your tax and investment advisors if you would like further information.
About the Author: Phil has more than 30 years of tax and legal experience working with companies, their ownership and management. He has extensive experience in advising companies regarding the tax and business implications of various transactions, including formations, reorganizations, acquisitions and dispositions. Phil practices in the areas of estate planning, international tax planning and reporting. He represents companies and individuals before the Internal Revenue Service and state tax authorities on audit and collection matters. Prior to joining LWBJ, Phil was a Senior Tax Consultant with Arthur Anderson & Company, Director of Tax for Energy Fuels Corporation and an attorney in private practice. He received his BBA in Accounting and Juris Doctorate from the University of Iowa. Phil can be reached by calling 515-224-7858 or emailing email@example.com.
PLEASE NOTE LIMITATIONS: Please see Important Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com/info-disclosure/. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.