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When employees leave a job that had a company retirement plan, it’s customary to roll over the plan’s 401(k) into a traditional IRA. This provides a great way to continue deferring taxes on the account’s earnings until you retire and begin taking distributions.
Or it does, at least, for most of the plan’s assets. But if your 401(k) includes publicly held stock in the company you’re leaving, you shouldn’t automatically roll these assets over to an IRA. It may make more sense to instead move the stock to a brokerage account and pay at least some tax on it immediately.
Here’s a rundown of why that’s the case, along with advice on how you should proceed in handling company stock when you depart a company. The explanation gets a little complex in places, but it’s worth reading. Thousands of dollars in tax liability could be at stake.
Key Takeaway
- Rolling over your 401(k) money into an IRA can be a good way to defer taxes until you retire and begin to take distributions.
- But if your account includes publicly traded stock in the company you work for, you can save money by withdrawing it from your 401(k) and putting it in a taxable brokerage account, for more favorable tax treatment.
- The difference between the stock’s value when acquired and its current value, known as its net unrealized appreciation (NUA), is then subject only to capital gains tax, rather than the more costly income tax.
- The only part of your company stock that is subject to ordinary income taxes is the value of the stock when it was first bought by the 401(k) plan.
- This move also confers benefits to those who may inherit the stock, since they too will enjoy a more favorable tax arrangement on the stock.
Net Realized Appreciation (NUA) Explained
The underlying reason to pause before rolling over company stock can be summarized in three letters: NUA, for net unrealized appreciation. The NUA is the difference between the value of the company stock at the time it was purchased, or given to you and put into your 401(k) account, and what it’s worth when it’s transferred out of the 401(k).
How that appreciation in the stock’s value is ultimately taxed depends on the account to which the stock is transferred from your 401(k). If the transfer is to an IRA, you don’t pay any tax immediately, which is helpful. But you’re liable to pay income tax on the stock’s full NUA when you sell it.
Moving the stocks to a brokerage account, on the other hand, requires you to pay income tax immediately on the cost basis of the stock—what it was worth when you acquired it. But there’s a long-term advantage. When you eventually sell the stock, the NUA will be taxed as a capital gain, at rates that are almost certain to be lower than those you pay in income tax.
If the stock has risen a lot in value, you could save thousands of dollars by paying income tax on the stock now and gaining a more favorable tax treatment for the remainder of its value when you sell the stock later.
Using NUA Helps Avoid Required Distributions
Avoiding an IRA transfer for your stock also allows you to skip being forced to disburse some of their value under the IRS rules for retirement accounts.
Company stock held within an IRA becomes subject, like all retirement account assets, to required minimum distributions (RMDs). That is, once you turn 72, a certain amount of the value of the account must be taken out annually. To do so, you may have to sell some of the company stock, if you can’t or don’t wish to tap other assets in the account to satisfy the RMD requirement.
By contrast, when you take advantage of the NUA tax break for your company stock (by not rolling it over into an IRA), you’re free to sell the stock whenever you wish, since it will be free of the distributions demanded by an IRA.
NUA: A Plus With Quick Stock Sales
It’s also advantageous to hold company stock outside an IRA if you wish to sell your company stock immediately after you depart the organization. With most stocks, you’re required to have held them for at least a year to have them taxed as capital gains, rather than as income. Not so with stock that’s been transferred from your retirement plan to a brokerage account. You’ll be free to sell the shares the day after you transfer them out of your 401(k), and pay only the current capital gains rate on the NUA, rather than the income tax rate you’d pay were they held in an IRA.
One caveat, though: This break does not apply to any further appreciation in the stock after it is transferred out of your 401(k). Let’s say you decide to wait to sell because you believe the stock will rise further in value. Any such increase between the transfer from your 401(k) and the sale is subject to the usual rules for capital gains. That is, the gain will be subject to income tax unless you hold the securities for more than one year before selling.
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The number of American workers who have access to a 401(k) or another retirement plan through their employer and choose to participate in the plan.
Any dividends earned on the stock before you sell it are also taxable at your ordinary income tax rate.
These same benefits flow to your heirs if they inherit company stock that was transferred by you from a 401(k) to a brokerage account. As with you, the heir can sell the stock immediately and pay capital gains tax. Further, your heir gets favorable treatment when it comes to how that gain is calculated.
The heir pays capital gains tax not on the full appreciation in the stock’s value from its cost basis—as in what it was worth when you acquired it. Rather, under what is known as a step-up in basis, the heir pays only on any appreciation since the time you died.
The net result is that your heirs skip paying tax on any rise in value in the stock during the time that you owned it. That would not necessarily be the case if they inherited the stock as part of an IRA rather than in a brokerage account.
To get the tax break that is available for company stock in a retirement plan, you’ll have to pay some money upfront, which could discourage investors. But you’ll most likely come out ahead, paying fewer taxes in the long run.
How NUA Can Save Taxes: A Case Study
Let’s go through an example to demonstrate these tax treatments.
Mike is 57, about to retire, and has company stock in his 401(k) plan. The original value of the stock was $200,000, but it is now worth $1 million. If he were to roll the $1 million over to his IRA, the money would grow tax-deferred until he took distributions. At that time, the distributions would be taxed as ordinary income.
Also, if Mike didn’t sell the stock before he dies, the beneficiaries of his IRA will pay ordinary income tax on all of the money they receive, including the current value of the stock.
If, on the other hand, Mike withdraws the stock from the plan rather than rolling it into his IRA, his tax situation would be different, as would that of his heirs. He would have to pay ordinary income tax on the original cost of $200,000. However, the remaining $800,000 would not be subject to his ordinary income tax because of the NUA tax break.
If Mike immediately sold the stock, he would have to pay only the lower capital gains tax on that $800,000 NUA. Let’s say that Mike instead holds the stock for a few months before selling it. When he sells, he pays capital gains tax, rather than income tax, on the NUA before he transferred the stock to his brokerage account, and on any additional appreciation since then. And because the stock is not a part of an IRA, he does not have to worry about RMDs from the account, based on the stock’s value.
Also, if Mike does not roll the stock into an IRA, his beneficiaries, too, would get a break. If they sell immediately, they’d benefit from a step-up in basis to the value of the stock when Mike died. Consequently, they’d pay capital gains tax only on any appreciation in value between Mike’s death and their sale of the stock, and not on the $800,000 the stock appreciated in value over the time that Mike owned it.
Let’s summarize the difference between Mike not rolling his 401(k) assets into an IRA (taking advantage of the NUA tax break), and Mike rolling into an IRA. We’ll assume that he is in the 35% tax bracket.
Here is the comparison if Mike immediately sells the stock:
Say Mike doesn’t sell immediately and keeps the stock in the brokerage account. The value increases to $1.5 million in five years, and then he decides to sell.
| Company Stock That’s Held and Appreciates: Taxes Outside and Within an IRA | ||
|---|---|---|
| Not Rolling to IRA | Rolling to IRA | |
| Taxable amount | $1.3 million ($200,000 was already taxed upon transfer from 401(k)) | $1.5 million |
| Tax rate | 15% (lower capital gains tax) | 35% (ordinary income tax) |
| Potential amount of tax Mike must pay | $195,000 | $525,000 |
| Plus amount of ordinary income tax previously paid | $70,000 | |
| Total tax | $265,000 | $525,000 |
Finally, assume that Mike died five years after the stock increases to $1.5 million. What would his beneficiaries have to pay?
| Company Stock That’s Inherited: Taxes Outside and Within an IRA | ||
|---|---|---|
| Inheriting from Regular Brokerage Account | Inheriting from IRA | |
| Taxable amount | $800,000 | $1.5 million |
| Tax rate | 15% (lower capital gains tax) | 35% (ordinary income tax) |
| Tax paid | $120,000 | $525,000 |
| Amount receiving step-up in basis (the amount that is tax free) | $500,000 (the amount the stock appreciated since Mike distributed it from the 401(k)) | |
| Total Tax | $120,000 | $525,000 |
When NUA May Not Save You: An Example
Let’s go through an example where using the NUA advantage may not make much sense.
Bob is 59, about to retire, and has company stock in his 401(k) plan that’s currently worth $15,000, but has a cost basis of $10,000. He’s currently in the 25% ordinary income tax bracket, which means that he pays a 15% tax on long-term capital gains—and would pay that on a sale of company stock that had been moved from a 401(k) to a brokerage account.
Let’s further assume that Bob waits a year to sell the stock, during which it appreciates in value by a further $2,000. He also retires, dropping his income and income tax rate (to 22%, from 25%). Further, in the case of rolling the stock over to an IRA, he invests the $2,500 he saved in income tax—albeit conservatively—in a 1-year CD, which as of August 2019 was earning about 2.5%.
Here’s how the numbers fall out between rolling the stock over to an IRA and moving it to a brokerage account:
| Company Stock That’s Held and Appreciates: Taxes Outside and Within an IRA | |
|---|---|
| Not Rolling to IRA | Rolling to IRA |
| $10,000 cost basis immediately subject to income tax at 25% = $2,500 | $17,000 value ($15,000 plus $2,000 appreciation) subject to income tax at 22% when stock sold after a year = $3,740 |
| $7,000 appreciation ($5,000 within the 401(k), $2,000 since moving from it), subject to capital gains tax at 15% = $1,050 | |
| Total tax: $3,550 | $3,740 |
| -Earnings on a $2,500 1-yr. CD: $63. | |
| Difference: $127 | |
These calculations show that moving the company stock to an IRA might cost only $125 or so more in tax than moving it to a brokerage account, and then benefiting from the NUA advantages. And that cost difference is liberal, in that it doesn’t account for the possible costs of borrowing money to meet the immediate tax bill from the brokerage option, nor the possibly higher investment earnings if those tax savings were invested in a less conservative vehicle, such as a mutual fund. That could close the cost gap to little or nothing.
The bottom line is that such a slim advantage for moving the stock to a brokerage account may not be worth the trouble.
Tips on Taking Advantage of NUA
Here are some fine points on fully using NUA to your advantage.
Consider Splitting up Stock
Suppose that some shares had a very low value when they were first contributed to your 401(k), while others did not. You could use the NUA on the cheaper shares and transfer the others to your IRA. If you acquired stock gradually over your career, some of the latest acquisitions that are yet to appreciate much or at all could be transferred to an IRA, which avoids paying any income tax now and allows the stock to further appreciate on a tax-free basis. The stock you acquired early, which has appreciated significantly, could be transferred to a brokerage account. Note, however, you can’t do partial NUA or partial rollovers.
Watch the Calendar
Also, remember that you will have to distribute and transfer your plan’s assets as a lump sum. This means all of the plan’s assets, not just the employer’s stock, must be removed within one calendar year. Therefore, since trustees can take several weeks to process such requests, make sure you give yourself enough time so that the distribution and transfer occur in the same year for maximum tax benefit.
Under 55? Weigh the Early-Withdrawal Penalty
Another potential downside is that if you are not at least 55 and leaving your job, you will have to pay a 10% penalty on the taxable amount in your 401(k), which for the stock is its cost-basis value. However, that also means that if the stock has grown enough (the NUA is worth more than the original amount), it could be worthwhile to pay the penalty in order to capture the NUA benefit.
Plan Around Withholding
When you distribute from your employer’s plan, the employer is required to withhold 20% from the distributions for the IRS, but you might be able to get around this. Have your employer transfer the non-stock assets directly to your IRA. Then have the stock distributed to you in kind. That way, there is nothing left in the plan for the IRS. But if you can’t avoid the tax, make sure your employer withholds only 20% on the cost basis, not the entire amount.
Consider Multiple Brokerage Accounts
Also, for record-keeping purposes, do not mix NUA stock with other company stock in the same brokerage account. Doing so could make it very difficult to get the tax break. Instead, set up a separate account to hold the NUA stock.
Get Help as Needed to Educate Your Employer
Finally, in case your employer is not familiar with the NUA tax rules and allowances, you may have to do some convincing. This might involve getting a competent financial advisor or accountant to intervene on your behalf.
How Much of my 401(k) Should Be in Company Stock?
Experts agree that you should put no more than around 10% of your retirement portfolio in company stock. Putting too much of your retirement plan in company stock can be problematic for a number of reasons. First, it reduces your portfolio’s overall diversification and concentrates your holdings in just one company. Second, your investment returns and employment prospects become linked – so if your employer has poor performance, you may end up losing both your job and your 401(k) value. Finally, your employer may place restrictions on the ability to buy or sell company stock, which limits the control you have on your finances and can cause liquidity issues.
How Does Company Stock Work in a 401(k)?
Generally, 401(k) plan participants cannot pick individual stocks. Rather, they must choose from a menu of mutual funds and ETFs. In this respect, company stock differs since it stands by itself as shares. Your employer may also offer a contribution match to your 401(k), not in cash but in company stock. In such a case, you may be able to sell those shares and reinvest them in other fund options.
What Percent of 401(k) Portfolios Do People Have Allocated to Company Stock?
According to industry research, on average, 401(k) plan participants’ portfolios consist 4.5% of company stock.
The Bottom Line
The NUA tax break strictly applies to shares in the company you work for. Other assets in the 401(k), such as mutual funds, do not receive it. And you should only consider taking advantage of the move if the stock has appreciated significantly from the time it was purchased by your plan. If it has not, you might be better off rolling it over to your IRA and letting it continue to grow tax-deferred, as you would the mutual funds and other plan holdings.
If it’s a close call whether keeping the stocks inside or outside an IRA will be more beneficial, some other factors may tip you in one direction or the other. The first might be the amounts involved: If the shares make up a significant amount of your net worth, the brokerage account may be more advantageous, where smaller holdings may make you more inclined to do a rollover, since the comparative tax impact may be small. Furthermore, assets held in an IRA have greater creditor protection than non-IRA accounts.
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