April 26, 2019
Rolling Over Company Stock: Make Sure You Understand Your Decision
Rolling Over Company Stock: Make Sure You Understand Your Decision
Whenever employees leave a job, they frequently roll over their 401K plan(s) into a self-directed IRA. Normally this is a great way to continue deferring taxes until you retire. However, if your 401(k) includes highly appreciated, publicly-traded stock in the company you work for, you could save thousands of dollars by paying taxes on the stock now rather than later. Internal Revenue Code Section 402(e)(4) defines the rules for getting favorable tax treatment of the “Net Unrealized Appreciation” (NUA) of employer stock held in an employer retirement plan, ultimately allowing gains that occurred inside the plan to be taxed outside the plan at preferential long-term capital gains rates.
How Not Rolling Over Can Mean Less Tax
When you distribute money from your IRA, you pay ordinary income taxes on those distributions (assuming your original contributions to the account were made with pre-tax dollars). Company stock rolled into the IRA is treated the same way.
But if you withdraw your company stock from your 401(k) by transferring the ONLY the company stock to a taxable brokerage account, you avoid ordinary income taxation on the stock’s Net Unrealized Appreciation (NUA) (regardless of whether you sell or continue to hold the stock). The NUA is the difference between the value of the company stock at the time it was purchased (and put into your 401(k) account) and the time of distribution (transferred out of the 401(k)). So, the only part of your company stock that is subject to your ordinary income taxes is the value the stock was when it was first acquired by the 401(k) plan.
In sum, because of this NUA tax break, it may be most beneficial for you not to roll over your company stock from the 401(k) into an IRA. (However, the other assets in the 401(k) – such as mutual funds, etc. – do not receive the NUA tax break, so you would still likely want to roll these plan assets into an IRA and continue deferring taxes on past and future growth.)
Requirements to Qualify for NUA Tax Treatment
Specifically, the NUA rules under IRC Section 402(e)(4) stipulate that if employer stock in an employer retirement plan is distributed in-kind as a lump sum distribution after a triggering event, then the cost basis of the shares will be (immediately) taxable as ordinary income, but the gains on the stock – the “net unrealized appreciation” that had previously occurred inside the plan – will be taxable at long-term capital gains rates. And under IRS Notice 98-24, the net unrealized appreciation will always be taxed at long-term capital gains rates, regardless of the actual holding period of the stock inside the plan.
Notably, to meet the requirements for the NUA rules, there are three very specific requirements that must be met:
1) The employer stock must be distributed in-kind. This means it must actually be true employer stock, that is able to be transferred in-kind. Selling the stock shares, transferring cash, and repurchasing the shares outside the account doesn’t count, and TAM 200841042 similarly declared that an ESOP must actually transfer shares (or share certificates) out of the account, not merely liquidate them at termination and roll over the cash proceeds. Similarly, “phantom” stock or stock options aren’t eligible for NUA tax treatment either, although an employer stock fund does qualify, as long as it holds only cash and shares of company stock and can be converted into individual shares of employer stock that can be transferred in-kind. To complete the in-kind distribution, the employer stock should be transferred directly to a taxable investment (i.e., brokerage) account.
2) The employer retirement plan must make a “lump sum distribution”. In this context, a “lump sum distribution” means the entire account balance of the employer retirement plan must be distributed in a single tax year. It’s important to recognize that this doesn’t just mean all the stock must be taken out of the plan; it means the entire account must be distributed. Although ultimately, it’s up to the plan participant to choose where the dollars end up; it is permissible to do an NUA distribution for just some of the account and roll over the rest directly to an IRA (or even convert to a Roth). However, none of the money can stay in the plan past the end of that year.
3) The lump-sum distribution must be made after a “triggering event”. In order to be eligible for NUA treatment of an in-kind distribution of employer stock, the lump-sum distribution must be made after a triggering event. The triggering events are (a) Death, (b) Disability, (c) Separation from Service, or (d) Reaching age 59 ½. Notably, this means that an in-service distribution generally does not qualify for NUA treatment, unless it is a distribution that also happens to occur after a triggering event (e.g., upon reaching age 59 ½).
NUA Tax Treatment at Distribution and Subsequent Sale
As noted earlier, when the NUA distribution occurs, the cost basis of the shares (from inside the plan) are immediately taxable as ordinary income (and if not otherwise eligible for an exception, the 10% early withdrawal penalty may apply as well). The actual Net Unrealized Appreciation (i.e., unrealized gain above that cost basis) of the shares are taxable as long-term capital gains, but the capital gains tax event doesn’t occur until the shares are actually sold (although in many cases, due to a desire to diversify, the shares are sold as soon as they are distributed anyway). If the shares are held past the distribution, any subsequent gains will be taxed at short-term or long-term capital gains rates, based on the holding period from the distribution date until the subsequent sale. If shares are held past the distribution date and losses occur, it will simply reduce the amount of net unrealized appreciation gain reported on the sale (although if losses cause the price to fall all the way down below the original cost basis, a capital loss can be claimed).
To Sell or to Hold?
Say you sell the company stock shares immediately, instead of continuing to hold them in a regular brokerage account. For most stocks, when you sell them, you are required to have held them for at least one year to receive a lower capital gains tax rate on them, but this does not apply to the NUA. Therefore, you could sell the shares the day after you transferred them out of your 401(k) and pay only the lower current capital gains rate on the NUA. On the other hand, if you were to roll the stock into your IRA, you will eventually pay tax at a higher rate than your ordinary tax rate.
Say you decide to hold onto the stock from the 401(k) in your brokerage account. If the stocks appreciate further and you want to take advantage of the lower capital gains tax on that appreciation, you must hold the securities for more than one year before selling. Otherwise, any growth on the stock that occurred since the day it was moved out of the retirement plan will be taxed at your ordinary income tax rate. Future dividends are taxable at your ordinary income tax rate, too.
Benefits for Heirs
Beneficiaries to IRAs and other retirement plans must pay ordinary income taxes on all money they receive. The tax is based on your cost basis, which, for tax purposes, is generally zero since you haven't yet paid tax on the contributions. The zero-tax cost basis means that it cost you no taxes, so everything above that tax cost (which is zero) is profit and thus still taxable. In other words, a cost basis of zero for tax purposes means everything in the IRA is taxable for your beneficiaries. However, sometimes people will make after-tax contributions to an IRA plan. Those dollars would come out tax free on a pro-rata basis.
However, inherited NUA stock is treated differently. Your heirs still inherit your cost basis in the stock, but when they cash in the NUA stock, they are entitled to the same treatment that you would have received (i.e., pay no ordinary income tax). But they must also abide by the same rules (i.e. if they hold the stock and the stock appreciates, to receive a lower capital gains rate on that appreciation, they must hold the stocks for a year). So when your heirs receive inherited stock, they will pay only capital gains tax on the NUA.
If there was any appreciation between the date you distributed the stock from the 401(k) and the date you die, the value of the appreciation will receive a stepped-up-basis. This means that for tax purposes your beneficiaries receive the stock at the value it was on your date of death. So, if they sell it for the same price it was when they inherited it, there is zero tax on that appreciation. It therefore passes to them income tax-free.
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