I recently met with Dave, a long-term employee of a large company who came to me with a tinge of guilt in his voice. “You’re gonna yell at me, but I’ve got about 20% of my 401(k) invested in my company’s stock. I’ve been putting money in it since they started allowing me to, and it’s done about as good or better than my other stocks. The re-balancing tool on the plan website says I have too much company stock, and you’re gonna tell me to sell most of it – right?”
Though Dave was 59 and about 3 years from his retirement, and that stock was by far his single biggest holding, he was pretty surprised to hear my recommendation: “Before you touch that company stock, we need to check out what your other options are regarding the stock. Maybe you can distribute all or part of it under the Net Unrealized Appreciation (NUA) rule.” Like a lot of people before him, he just said, “That’s the first time I ever heard about something like that…what are you talking about?”
This rule that Dave and many of his fellow employees need to know about has been around for years, but the lowering of capital gains tax rates over time has boosted its value. Shares of employer stock in a company retirement plan can be distributed to a taxable account (i.e. regular brokerage) when a lump-sum distribution is made. The rule says that when the stock goes to that brokerage account and not into a rollover IRA, tax is paid – but only on the cost basis of the shares distributed.
After that, the stock takes that cost basis and if sold is subject to capital gains tax. The capital gains tax rate (typically 15%) will be at or lower than the ordinary tax rate they’ll pay in retirement if the stock even needs to be sold at all. (If not, there likely won’t be any tax on the gain when the stock is passed on to heirs.) It also keeps the stock from growing in the rollover IRA and being subject to required minimum distributions and higher ordinary income tax rates when paid out.
In this example, Dave had $108,000 of his company’s stock, and his statements said he had paid $46,000 for it over the years. We determined that trimming some of the shares and preserving about $75,000 of it (today’s value) would result in a $32,000 taxable distribution when he retires in June 2017. At that point, he’d pay ordinary income tax on the $32K at his lower 15% post-retirement bracket, and if he sells the stock later, any gains would be taxable at a rate of 15% or less.
If left in the retirement plan, the stock was projected to grow and produce continuing dividends, all of which would be subject to ordinary income tax rates. In Dave’s case, he wanted to keep the stock but buy a travel trailer – something he would be able to do at attractive rates with a stock-secured loan against the stock. If Dave keeps the stock (or part of it) until his death, the stock gets a stepped-up cost basis and the capital gain goes away.
One benefit Dave will give up is the creditor protections he has on assets in the retirement plan or rollover IRA, but in his case, the ability to get the stock out of his retirement plan and get dividend income and end up paying less taxes on it while still making one of his dream purchases outweighed the risks. The higher your tax bracket and the lower the amount you paid for your distributed company stock, the better the NUA rule should work for you. Dave said it best: ‘There’s no law against paying more taxes…but why would ya?”