There are significant tax-reduction opportunities available when employer stock is held in a 401(k) plan. The opportunities are more significant now, as are the potential consequences of a suboptimal decision, because prices of many stocks increased significantly in recent years.
Yet, many people diminish their benefits by rushing their decisions.
The key tax break is known as net unrealized appreciation, or NUA. It can be very valuable, but you must know and follow the rules.
If you sell employer stock while it is in your 401(k) or other retirement account, such as an ESOP, you do not get the tax break. The proceeds from that sale eventually will be distributed to you (from either the 401(k) or an IRA rollover) and be taxed as ordinary income.
There are choices you can make that would result in very different tax bills.
One option is to treat the stock the same as other assets. You either can keep the stock in the employer plan or roll it over to an IRA. In either case, in the future when shares of the stock or cash from sales of shares are distributed to you, the distribution is taxed as ordinary income.
The other option is to use the NUA strategy.
Step one in the NUA strategy is to roll over to a traditional IRA all assets in the retirement account that aren’t employer stock. The rollover should be tax free.
Step two is to distribute the employer stock that’s in the employer retirement plan to a taxable brokerage account. The shares must be distributed in kind and directly to a taxable account. They can’t first be rolled over to an IRA or other type of retirement account and later transferred to a taxable account.
In the year you make this distribution of employer stock, the original value, or cost basis, of the shares is included in your gross income and taxed as ordinary income. Taxes on the appreciation are deferred, no matter how much the shares appreciated since your retirement account acquired them.
The greater tax break comes later.
As you sell shares of employer stock from the taxable account, you pay long-term capital gains taxes on the appreciation that occurred since the employer retirement plan acquired the shares. Long-term gain treatment is allowed regardless of how long the shares were owned either inside or outside of the 401(k).
This can be a major tax break. Normally distributions from a retirement plan are taxed as ordinary income. This is the rare opportunity to both defer the taxes until you sell the stock and then have the appreciation taxed at long-term capital gains rates.
Here’s the most important rule and where many people try to qualify for the NUA tax benefits but fail.
To receive the tax-favored treatment, you have to take a lump sum distribution from the 401(k) plan. The tax code definition of lump sum distribution is that all the assets without exception are distributed from the account in the same calendar year.
All the assets that aren’t non-employer stock either should be distributed to you (which will cause them to be included in your gross income) or rolled over to an IRA. All the employer stock must be distributed to a taxable account of yours. These transactions must occur in the same calendar year.
Another rule for NUA treatment is you can’t have taken any withdrawals from the retirement plan in previous years, even required minimum distributions.
One more qualification for NUA treatment: The lump sum distribution must occur after a triggering event. Triggering events are attaining age 59½, leaving the employer’s service, or death. You can leave the employer’s service either voluntarily or involuntarily.
The lump sum distribution and triggering event don’t have to occur in the same year. For example, you can take the lump sum distribution years after turning age 59½ or leaving the employer.
The NUA treatment of the employer stock is the same whether your account purchased the shares or received them as a contribution from the employer.
The company’s stock doesn’t have to be publicly traded. Many private companies regularly determine a value for their stock, which can be used to determine your basis. When the stock is distributed to you, the employer should tell you its basis.
But some private companies have ownership restrictions that prevent the use of the NUA, because the stock isn’t allowed to leave the employer retirement plan.
NUA treatment also is available to heirs who inherit an employer retirement account and take a lump sum distribution after the employee’s death. And it’s available to divorced spouses who receive part of the retirement account under a qualified domestic relations order.
You don’t have to use the NUA treatment for all the employer stock in the account. Some shares can be rolled over to an IRA, where they won’t receive NUA benefits.
If someone took advantage of the NUA treatment by transferring the shares to a brokerage account and held the shares until death, the heirs do not increase the tax basis of the shares. The heirs will owe capital gains taxes on the appreciation when they sell the shares just as the employee would have.
For most people NUA treatment is the best way to handle employer stock held in a retirement account.
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