Did you know that there is a way to save thousands if not tens of thousands in taxes if you own your company’s highly appreciated stock inside your 401K?
I recently began working with a prospective client who owned his companies’ stock in his 401K. As we were getting to know each other, he mentioned how well the company stock was doing. As I began to look through his statement, I realized not only was the stock doing well, but he had over $600,000 of appreciation.
To provide a little context, we were in the beginning stages of creating a financial plan as he was thinking of retiring in the next couple of years.
He came in with the question that many people have when thinking of retiring. Have I saved enough to retire comfortably without running out of money or changing my lifestyle too much? One of the five key points of our Retirement Compass is tax planning. The others are income planning, investment planning, health care planning, and legacy planning. We believe, and history has shown, that proper planning in these five areas provide our clients with peace of mind as they enter their retirement years.
The Retirement Compass tax planning process includes strategies for decreasing tax liabilities by assessing the taxable nature of current holdings. We also look for ways to have tax-deferred or tax-free money. Determine which accounts to withdraw cash from first to reduce the tax burden. Then, we look at ways to leave tax-free dollars to beneficiaries.
Upon the realization of the significant appreciation in the company stock, I knew the special treatment of Net Unrealized Appreciation (NUA) of company stock in a 401K may be an option.
NUA is simply the gain above your cost basis of a particular investment.
Doesn’t seem like a big deal, right?
Simply put, NUA changes the way the appreciated stock is taxed from ordinary income to long-term capital gains. Internal Revenue Code Section 402(e)(4) provides the rules for how you can receive special tax treatment of company stock held in your employer-sponsored retirement plan. Keep in mind, distributions from your tax-deferred accounts are taxed as ordinary income. When you reach age 72 (under current tax law), you are required to take required minimum distributions (RMDs) from tax-deferred accounts regardless of if you need the income or not.
Here’s an example. Jimmy works for ACME Inc. that offers a 401(K) profitsharing plan. Jimmy has contributed $200,000 to his account in which he buys company stock. ACME has grown significantly over the years, and the
stock has done well, increasing the value to $800,000.
Under standard distribution rules, all distributions would be taxed as ordinary income whenever Jimmy takes a distribution. Most likely, Jimmy would take distributions over time as needed.
Instead of taxing the entire amount as ordinary income, the government allows Jimmy to take money out of the plan and have the NUA taxed at long-term capital gains rates instead of ordinary income tax rates. In this case, the NUA would be $600,000 (current market price $800,000 minus his basis of $200,000).
The basis will still be taxed as ordinary income in the year of the distribution. It could be subject to the 10 percent early withdrawal 72(t) penalty tax if the withdrawal occurs before Jimmy turns 59 ½. The NUA portion, $600,000, would be taxed at long-term capital gains rates when the stock is sold.
In this case, Jimmy’s ordinary income rate is assumed to be an effective rate of 24 percent. His long-term capital gains rate is 15 percent. He would pay a total of $192,000 in taxes on the $800,000 account at ordinary income tax rates. Jimmy would pay $138,000 (.24 x $200,000 plus .15 x $600,000) with the NUA strategy. That’s a tax savings of $54,000 –pretty significant savings, nearly 7 percent of his retirement portfolio. This example simplifies the tax situation a lot. Still, it does demonstrate how significant tax savings can be under the strategy.
Each situation is different and there are several variables that need to be taken into account to determine if this strategy is appropriate for you. Give us a call and we will help you chart the best course of action.
Investment Advisory Services are offered through Retirement Wealth Advisors, Inc. (RWA), an SEC Registered Investment Advisor. Stonebridge Insurance and Wealth Management and RWA are not affiliated. Investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Past performance does not guarantee future results. Consult your financial professional before making any investment decision.