There are good reasons to move most of a client’s 401(k) assets into an IRA when they leave a job. But a client with highly appreciated employer stock in retirement plans is often better advised to transfer those shares — and only those shares — into a taxable account.
The reason is a tax wrinkle known as the net unrealized appreciation rule.
When employer stock is transferred from a 401(k) to a taxable account, the shares’ cost basis is subject to ordinary income taxes, plus a 10% early withdrawal penalty if the client is under 55. But the appreciation isn’t taxable until the shares are sold, and then only as a long-term capital gain. By contrast, the entire value of employer stock that goes into an individual retirement account is eventually taxed as ordinary income.
This rule is little-publicized. Indeed, major 401(k) record-keepers don’t always list the NUA election as an option on their off-the-shelf distribution forms. (One reason may be that some plans don’t make it available.) Retirement-plan experts say even sophisticated 401(k) participants are unaware of the NUA choice.
“I had one client where the chief financial officer was surprised to learn about it,” said Alec Dike, an attorney in the Chicago office of Watson Wyatt Worldwide, an employee benefits consultant.
The more employer stock has appreciated in the client’s 401(k) account, the more compelling the case for an NUA transfer. Nevertheless, this isn’t a no-brainer, said Loretta Nolan, a certified financial planner and tax accountant in Old Greenwich, Conn.
Some factors to consider include how soon the client will leave their job, their current ordinary income-tax bracket, whether they have funds available to pay the tax on the transfer — there’s no 20% tax withholding on NUA transfers, as there is on other taxable 401(k) distributions — and perhaps most importantly, the concentration of employer stock in the client’s total portfolio.
Ms. Nolan frequently sees clients whose company stock represents at least 50% of their investible assets. A client with a lot of employer stock in their 401(k) usually also has a stock purchase plan, stock options and restricted stock, she explained. And, of course, they’re employed by the company. That’s a lot of eggs in one basket. If your client won’t leave this job for another 20 years, the risks of being undiversified outweigh the future tax benefit.
“Even if the client is nearing retirement, you want to minimize the risk of a highly concentrated position while preserving the opportunity of NUA,” Ms. Nolan said.
To do that, she analyzes all the employer stock in the client’s portfolio, looking for shares that can be sold outside the 401(k) plan, such as shares in the stock purchase plan that already qualify for capital gains treatment, or nonqualified options, which are taxed as ordinary income no matter when they’re sold. Senior executives are legally barred from buying put options on employer stock, Ms. Nolan said. “But for a middle-management person, that might be a way to hedge the risk.”
An NUA transfer is available to anyone leaving a job, provided it’s part of a lump-sum 401(k) distribution, that is, a complete distribution of all plan assets in a single calendar year. Lump-sum 401(k) distributions to the participant’s beneficiaries also qualify for NUA transfers, and so does a distribution to an ex-spouse under a qualified domestic relations order, said Bob Walter, an attorney at Buck Consultants LLC in Secaucus, N.J.
But to be eligible, the stock must be an in-kind transfer. “You have to make sure the 401(k) plan trustee doesn’t sell them for you,” Mr. Dike explained. The client should request the NUA transfer in a letter that goes both to the plan’s record-keeper and their employer’s human resources department. “If the letter duplicates the 401(k) plan’s distribution election forms, it won’t do any harm,” Mr. Dike said.
Make sure you allow time to find out the shares’ cost basis, which determines the tax cost of the transfer, Mr. Walter said. “That information may not be quickly accessible to the plan participant.”
After the NUA transfer, Ms. Nolan advises selling the employer stock without delay. “I look at this as a package,” she said.
“The first step is taking advantage of preferential tax treatment at a time when the capital gains tax is very low,” Ms. Nolan said. “The second step, which I find just as important, is to diversify afterwards.”
The longer you wait to sell the stock, she pointed out, the greater the risk that capital gains tax rates will rise and/or the stock’s price will fall, wiping out the NUA benefit.