If your 401(k) includes your company's stock, a rollover may be a bad move
When employees who own company stock in their 401(k) or profit-sharing plan retire or leave their employer, they have to become experts in evaluating what to do with that money.
That means learning about "net unrealized appreciation" or NUA.
Thanks in large part to the Enron fiasco, fewer workers invest a large chunk of their 401(k) in their own company's stock. The portion of participants' savings invested in company stock has dropped steadily over the years, to 13% in 2005 from 19% in 1996.
But that 13% still represents a huge chunk of money for many 401(k) participants. And it represents a crash course in NUA.
At present, workers leaving their company have four options, according to Robert Keebler, a partner with Virchow, Krause & Company, who wrote a brief on the subject for MFS. They can:• keep the stock in their employer's plan;
• transfer the securities to an IRA via a tax-free rollover;
• take 100% of the securities out via a lump-sum distribution; or
• transfer a portion of the securities to an IRA via a tax-free rollover, while taking the remaining portion out as a lump-sum distribution.
Typically, workers often transfer their securities to an IRA via a tax-free rollover, but that's not always the wisest choice, Cortazzo says. "You get one shot to do it and to do it right," he says. "Once you do the transaction, you can't get the horse back into the barn."
Deciding which option to use requires both knowledge of income tax laws and a thorough understanding of one's finances. For instance, Uncle Sam will - without getting into the nitty-gritty just yet - ultimately tax a worker's stock at ordinary income tax rates if they transfer it into an IRA.
By contrast, Uncle Sam will - again without getting into the nitty-gritty just yet - eventually tax a worker's stock at the capital gains tax rate if they transfer all or a portion of their stock into a taxable account.
Get the cost basis
Ah, but the nitty-gritty can complicate things. Here's what Cortazzo says workers should consider when they invest in their employer's stock in their 401(k) plan.
First, long before contributing dollar one in company stock, workers should ask those responsible for the retirement plan, typically the human resource department, how the cost basis of the company stock purchased is determined. And workers should get the answer in writing. Ultimately, when it comes time to leave the company, knowing how the employer calculates the cost basis will play a big role in deciding which option to choose. Some firms use tax lot accounting while others use average cost, Cortazzo said.
The cost basis is, in essence, the amount the retirement plan paid to buy the employer's securities over the years the worker was a plan participant.
Why is the cost basis important? First, it's used to determine how much ordinary income tax a worker would pay if he transferred all or part of his stock into a taxable account.
Second, it's used to determine what the capital gains tax would be once the worker sells the stock.
For instance, if the cost basis is $10,000, the worker would be taxed in the year of distribution at the ordinary income tax rate on that amount. According to Keebler, any appreciation in the securities from the purchase date until the distribution date is known as NUA.
Thus, if a stock is worth $100,000 on the day the worker takes the stock out of the plan, the NUA would be $90,000. Better yet, the worker wouldn't have to pay tax until the stock is sold -- and even better yet, it would be taxed at the capital gains rate. Stock sold within 12 months could result in a combination of long- and short-term capital gains, while stock sold immediately after distribution or after 12 months will have just long-term capital gain. (Of note: workers who have any capital loss carryovers might want to take advantage of any NUA stock they own. Capital losses are fully deductible against capital gains so workers can use the NUA to wipe the slate clean, Cortazzo said.) In some cases, workers might want to gift their NUA shares to a charity. That way the charity can sell without incurring any tax.
The other important aspect of NUA is this: To use NUA, the distribution must first qualify as a lump-sum distribution. According to Keebler, a lump-sum distribution is simply a distribution of all the assets in a qualified plan within one tax year. To get the special NUA tax treatment, however, one of the following triggering events must occur:• the distribution must be taken from a 401(k) or similar plan;
• the entire balance must be paid to the account owner;
• the entire distribution must take place within one tax year, by Dec. 31st.
To be sure, there's plenty to consider when it comes to NUA. Workers, for instance, who are under age 55 will have to pay a 10% penalty tax on the cost basis of the distribution. In addition, it's possible that some stock in the 401(k) plan qualifies for NUA and some doesn't, so be sure to separate those two types when transferring assets. According to Cortazzo, one difference between NUA and non-NUA shares is that NUA shares don't get a step-up in basis when inherited, while non-NUA shares do.
Lump-sum or rollover?
So what should workers do? Take the lump-sum distribution or the rollover?
According to Natalie Choate's bible on the subject, "Life and Death Planning for Retirement Benefits," most retiring employees should consider a rollover, the lone exception being when the lump-sum distribution includes appreciated employer stock. If you roll the stock into an IRA, the worker loses any chance to defer taxes on the NUA, plus rolling the stock into an IRA converts an unrealized capital gain into ordinary income.
According to Choate, factors to consider include the following:
• How old is the worker? Young workers might want to consider the rollover while older workers might opt for the lump-sum distribution.
• What other plans does the participant have? If the worker has plenty of money stashed in other retirement plans, the lump-sum distribution makes sense. But if the worker has just one plan, the rollover makes better sense.
• How much of the distribution is NUA? If the NUA is a big portion of the plans' value, the NUA deal is more attractive. If the NUA is a small portion, the rollover is better.
Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.