Most employers that are publicly traded companies offer employees the ability to buy company stock within their retirement plan. If this happens to be an option within your company 401(k) and you decide to take advantage of it, beware of your distribution options when you decide to retire. Many soon to be retirees make the mistake of rolling over the entire balance of their 401(k) into an IRA before fully understanding the options available to them. This is often done out of ignorance for the rules or lack of working with a qualified financial planner, and the consequences can be costly.
Imagine you had the option to distribute one investment out of your 401(k) account only paying ordinary income taxes on its basis, while deferring any other gains to a point in the future. Furthermore, when you decided to sell those future gains would be taxable at the more favorable capital gains rates. This, my friend, is the option you have with the company stock position in your 401(k), and it goes by the fancy name of Net Unrealized Appreciation (NUA).
The reason you may want to do this instead of rolling over your entire balance to an IRA comes down to the taxes you will eventually be paying upon distribution. To give you an example I will use a fictitious company named XYZ Corporation. Let us assume you have worked for XYZ Corporation for 30 years, and are on the cusp of retirement with 30% of your $500,000 401(k) balance held in company stock. Let us further assume you have a basis in that $150,000 (5000 shares current value of $30/share) position of only $60,000 (5000 shares at $12/share) because you have been a diligent buyer for so many decades. If you decide to execute a NUA distribution, you will pay ordinary income taxes on the $60,000 basis leaving the Net Unrealized Appreciation of $90,000 to be taxed at long-term capital gains rates when sold in the future.
If you are married filing jointly with a household income of $100,000 this distribution would be taxable at the 22% ordinary income tax bracket (based upon 2020 IRS Table) resulting in a tax of $13,200. Suppose a year or two from now you finally decide to go on that all-inclusive 14-day European river cruise that costs $16,000. You would have to distribute $20,513 from your IRA account to net $16,000 or you could sell $16,000 (533 shares at $30/share) of your NUA XYZ stock realizing a long-term capital gain of $9594 ($30 - $12 times 533 shares) that is taxable at the favorable 15% rate or $1439. The difference between these two options is $3074, which could go a long way in paying for upgraded flights or a myriad of other interesting journeys on your first big retirement excursion.
Planning for a successful retirement takes a lot of preplanning and knowledge. This is just one example of the value a qualified financial planner can provide to you and your family ensuring you live your best life.
Janney Montgomery Scott LLC does not provide legal tax or accounting advice and the information contained herein should not be construed as such. The example provided is hypothetical and does not take into account any specific situation. The hypothetical example is provided to help illustrate the concept discussed and does not consider the effect of fees, expenses, or other costs that will effect investing outcomes.