One of our clients, Robert (not his real name), was getting ready to retire from a job he held with a private engineering firm in 2003. What made his pending retirement unique was the way his 401(k) plan was invested. Of the $750,000 in his plan, $300,000 of it was in company stock.
And, believe it or not, that fact opened up a real planning opportunity for him.
You see, a few years ago Congress passed legislation allowing for special, more tax-friendly treatment of employer stock inside a 401(k) plan . . . but it doesn’t just happen this way . . . you have to plan for it. And, this strategy is a bit obscure, and not only did our client not know about it, but neither did his tax-preparer!
Essentially, here is how this special rule works: Normally, when you take money out of a qualified retirement plan, such as a 401(k) or an IRA, each distribution is taxed as if it is ordinary income, just the same as your wages would be from your job. But, if you follow the proper steps, company stock inside a 401(k) plan can qualify for capital gains tax treatment, which is typically taxed at a lower rate than ordinary income.
So, in Robert’s example, he had $300,000 in employer stock inside his 401(k) plan that we wanted to help him save taxes on, and here’s how we did it.
Step one is to determine the cost-basis of the stock, and this is something that the administrator of the retirement plan is required to calculate. In his case, we found out that his cost basis was $42,000, which means that his “profit” in that company stock was $258,000. The legal term for this profit is “Net Unrealized Appreciation” or “NUA” for short.
Next we had to establish two accounts – an IRA to accept the portion of the 401(k) that was not in company stock (about $450,000) and a traditional non-IRA brokerage account to hold the company stock.
Along with our client, we contacted his 401(k) administrator and instructed them to roll over the $450,000 into his IRA and to withdraw and deposit the $300,000 of company stock into his brokerage account. By doing so, the cost-basis of his stock ($42,000) was considered ordinary income immediately and recorded as such on his tax return for that year.
That is the “trade-off” . . . you have to pay tax on the cost-basis in order to have the profit (the NUA) taxed at more favorable capital gains rates.
In his case, however, it really worked out well for him.
Now, his company, being privately held, mandates that only employees can own stock, so, when we moved his stock into a brokerage account, it was only for one day. The company immediately bought back all the stock which resulted in our client having to realize this long-term capital gain of $258,000. But, the “happy ending” to this story is that, while the cost-basis of $42,000 was taxed at ordinary income tax rates, in his case 28%, the capital gains tax rate that he ended up paying on his NUA was only 15%!
Had he just done a normal IRA rollover of his entire 401(k) balance, which is what most people do, then the entire value of the company stock would have been lumped together with his other money and eventually everything would have been taxed at ordinary income tax rates. But, because we used the strategy of setting up two accounts and requesting that the stock be sent to its own account, we created an environment for him to save on his taxes.
How much did he save?
Well, had he paid taxes on the entire $300,000 stock value at 28%, his tax bill would have been $84,000. But, by embracing the NUA rule, only a portion of the stock value would be taxed at 28%, with the majority of it taxed at 15%:
|Cost-Basis||$42,000 x 28% = $11,760|
|Net Unrealized Appreciation||$258,000 x 15% = $38,700|
This strategy saved our client a whopping $33,540 in taxes! Sometimes just knowing how to take advantage of the “rules” can really impact our clients in a very meaningful way.
* These are case studies and are for illustrative purposes only. Actual performance and results will vary. These case studies do not constitute a recommendation as to the suitability of any investment for any person or persons having circumstances similar to those portrayed, and a financial advisor should be consulted.