If you have company stock sitting in your 401(k) account, you'll have to tackle more complicated choices when leaving your job than the folks who are only ushering plain old vanilla mutual funds out of the building.
For most people, the very best place to park an old 401(k) is in an Individual Retirement Account. When you do this, your nest egg will repel all taxes as long as it stays put.
If you're departing with a company stock bonanza, however, a wiser strategy could very well be to make sure your appreciated stock doesn't get anywhere near your new IRA. Instead, you'd park your shares inside a taxable account and pay income taxes.
For anyone hard-wired to avoid taxes, this advice will sound wacky. After all, if your stock is sitting inside an IRA, you could postpone the tax tab for many years, if not decades. The motivation for this contrarian move, however, is unassailable. By herding your stock into a separate corral, you can shrink your ultimate tax burden through an obscure tax break called net unrealized appreciation.
Here's an example of how NUA works: Suppose you have $150,000 worth of company stock in a 401(k) that you acquired over the years for just $25,000. The profit, or NUA, is $125,000, but if you move the shares to a taxable account, you'll only owe immediate taxes on the $25,000 cost basis.
If you're in the 25 percent tax bracket, for example, your tax bill would be $6,250. A 401(k) investor who is under the age of 55 would also have to pay a 10 percent early withdrawal penalty. The penalty, however, is assessed on what you paid for the stock and not its current value.
If you ever unload your company stake, you'd also face long-term capital gains taxes on the profit. If you hold onto your shares in the taxable account for more than one year, the maximum rate tops out at 15 percent. And that's one of the true beauties of the NUA tax break. But to appreciate why this can be such a great maneuver for stock that's increased in value, you have to understand what would happen to your equity mother lode if you transferred it into an IRA.
It is true that you'd owe no taxes as long as the stock remained undisturbed inside the IRA. But it's when you sell the stock and begin pulling out the cash that the IRS will grab its cudgel and start swinging.
If you cashed out your stock position and withdrew the money, you'd owe income tax on the whole amount. Income tax rates, by the way, reach as high as 35 percent, and it's highly likely that selling a big block of stock would bump up your tax bracket. In this particular scenario, someone in the 25 percent tax bracket would pay $37,500 in taxes.
Now let's contrast this tax bill with the one that our guy who moved his stock into a taxable account ultimately paid. In addition to the $6,250 he'd owe in taxes initially, he'd pay an additional $18,750 if he ultimately sold the stock at the more desirable long-term capital gains rate. His total tax tab would be $25,000. That's a $12,500 difference.
If the NUA appeals to you, it's necessary that you play by the IRS' rigid rules. If you've already moved your company stock to an IRA, for instance, you can't repack the box and ship it to a taxable account and expect to qualify for the NUA treatment. Don't even try.
This strategy also won't work if you sell your company stock before moving it out of your 401(k). Do this and the tax break on what could be years of appreciation will disintegrate. Some employees, after belatedly learning about the tax break, have tried to resuscitate the tax advantage by buying back stock shares in their 401(k), but this maneuver is also futile. You'd have to start from scratch in rebuilding the appreciation with your new shares.
Here's another rule you must follow: To qualify for the favored tax treatment, you have to empty your 401(k) in one tax year. Let's say you leave your job in September and you transfer the company stock into a taxable brokerage account, but you wait until June to move the rest of the 401(k) into an IRA. That delay will scotch the NUA tax break.
Even many people who are aware of the NUA benefit probably don't realize it can outlive them. If you inherit a stockpile of company stock in a 401(k) plan, you can capture the NUA tax break by moving the stock portion of the 401(k) into your own taxable account.
Knowing about the NUA can be especially helpful to the children or grandchildren of deceased 401(k) owners. That's because the IRS forbids these beneficiaries, or anyone who wasn't married to a 401(k) owner, from rolling the workplace account into an IRA. Typically, the employer is eager to close out these 401(k) accounts, which means sons or daughters are typically stuck paying onerous income taxes on the cashed-out amount. With this NUA option, these heirs can at least stanch some of the tax hemorrhage.