The DUFF TORNEY Team

Michael Torney, CFP, J.D., LL.M. 

Executives who have worked for one company during much of their career can accumulate a significant amount of company stock in their 401(k)-retirement plan.  

Executives in this situation who are near retirement have a unique opportunity to save a sizeable sum in taxes on their investment in their own company’s stock. It is worth exploring as part of an overall investment strategy in retirement. 

What Happens to Investments in Company Plans at Retirement

When departing their company, one decision the executive must make is what to do with the assets in their 401(k) or other company retirement plan.  They can keep the assets in the 401(k), transfer them to an Individual Retirement Account (IRA), or withdraw them from the 401(k) and pay any applicable taxes. Or, they can choose a hybrid of those three options.  One hybrid approach for executives with company stock is to move the company stock into a taxable brokerage account and the remainder of the assets to an IRA.  

When pre-tax assets from a 401(k) plan (or other company retirement plan) are moved to a taxable account, such as a brokerage account, a person typically pays ordinary income tax on the current market value of the assets. But with company stock, there are very specific tax rules that may allow an employee to make an election so that ordinary income taxes are only paid on the cost basis of the stock — the taxes on the gains are deferred until the stock is sold and are subject to different tax rules. 

This little-known part of the federal tax code is called Net Unrealized Appreciation (NUA). Here’s an example of how an executive considering retirement can benefit from this strategy.   

At age 30, an employee begins a new job in middle management with a new company. Over the next 35 years, this person contributes money annually into a 401(k) retirement plan, with five percent going into company stock. The company is successful and by age 65, this person – who is now an executive – has a total 401(k) plan valued at $4 million. This amount includes $1 million in company stock. 

Investment Planning – Key to Tax Savings

As part of the retirement planning process, the executive requests an estimate from their 401(k) plan provider to determine how much he paid for the company stock. They learn the cost of the company shares bought over 35 years is $200,000. This means the company stock has appreciated by $800,000. 

Upon retirement, the executive takes $3 million of the $4 million and places it into an IRA.  No taxes are paid and these funds are invested in a diversified portfolio of stocks and bonds. Unless the executive decides to withdraw any money, it continues to grow and no taxes are paid until federal law requires withdrawals beginning at age 73. 

For the remaining $1 million in company stock, the executive opens a brokerage account. And here is where the NUA rules become beneficial. 

Ordinary income taxes must be paid, but they are only due on $200,000 – the cost of the company stock – and not on the full $1 million. However, this upfront tax cost could result in tax savings on the appreciation. 

This is because the appreciation in a subsequent sale of stock is taxed as a long-term capital gain, which is usually taxed at a much lower rate than if taxed as ordinary income. If the executive had rolled the entire $1M of company stock into an IRA, the $800,000 of appreciation would be taxed at ordinary income rates instead of (presumably) lower capital gains rates when distributed from the IRA. 

NUA can be a great tool for long-time executives and managers who paid a relatively low cost basis for their company shares. However, it should be evaluated with a financial planner before diversifying out of company stock or rolling over a retirement plan to another retirement account. 

For example, there may be additional tax benefits for those who want to donate some of their company stock to charities by setting up a Donor Advised Fund. 

And, it may help those who retire but experience an “income gap,” which generally is a period of lower income that some people experience after leaving work, but before Social Security, pensions, and other income sources commence. 

Executives considering retirement soon may have questions about how they can benefit from this strategy. If you may be eligible for this potential tax benefit and would like to discuss it as part of an overall financial strategy, contact our team at DuffTorneyteam@monetagroup.com. We offer a free consultation and are always available to discuss how we can help people maximize their wealth. 

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