Potential Downsides for Company Stock in a 401(k)

All tax strategies can be useful, but it is generally not recommendable to let the “tax tail wag the dog.” Trying to pursue this NUA strategy too aggressively can lead to you owning too much company stock and not having your portfolio appropriately diversified. You only have a few different triggering events, which means you only have a few opportunities to distribute the stock, possibly leading to overzealous distributions in the year in which they can be made. This can lead to paying taxes at a higher-than-normal tax bracket and not leaving as much money as you would normally leave in your retirement account, ultimately leading to higher taxes in the long run because all the investments held outside your retirement account are taxed every year. Your heirs do not receive a “step up in basis” on NUA shares upon your passing. You may be charged a penalty for an early retirement account withdrawal if you retire earlier than 59.5 years old, (although in some cases you can take penalty-free distributions as early as age 55). You cannot strategically convert these assets into Roth IRA assets over the years at a potentially low tax rate if they are taken as NUA; however, any amounts rolled into an IRA and not taken as an NUA distribution can still be converted to a Roth IRA. You will have to pay any applicable state taxes on the NUA withdrawal, which may apply equally to ordinary income and capital gains.

Keep in Mind 

• You will have to pay gains (for any price changes in the stock subsequent to the distribution) on any shares distributed from the retirement account and not sold immediately as either short- or long-term gains. 

• It is generally wise to keep the NUA stock in an account separate from other company stock to simplify your recordkeeping.  

• In addition, note that the NUA is not subject to the 3.8% Medicare surtax on net investment income. 

• You are allowed to “cherry pick” which shares of stock to distribute in kind to the brokerage account and roll the remainder into an IRA. 

• Your heirs are allowed to take an NUA distribution when you pass away if the shares are still held in the company plan. 

• If you separate from service before the age of 59.5, have a very highly appreciated employer stock position, and you need to make a distribution from your retirement account, you would have to pay the normal 10% early withdrawal penalty. However, the penalty will be calculated off of your cost basis. This means if you purchased shares for $1,000 that are now worth $50,000, you can withdraw the $50,000 in employer stock and only pay the ordinary taxes and 10% penalty on the $1,000 cost basis. Then you would only have to pay taxes on the remaining $49,000 at your current capital gains tax rate. 

• You may be able to take an NUA distribution and then strategically sell the shares off in small amounts over the years to keep your income limited to a level that allows for 0% capital gains rates. 

• You can use the NUA distribution to satisfy your first required minimum distribution if you are over the age of 70.5 when you retire so you only have to pay ordinary income taxes on a potentially low-cost basis amount rather than the full amount of your first distribution when you would have had to distribute money from your retirement account anyway. This can significantly reduce the taxes due on your first required minimum distribution.

Company Stock in a 401(k): Net Unrealized Appreciation

Net Unrealized Appreciation (NUA) is the name of a little-known tax break that can help save you money on taxes from employer stock held in a 401(k) plan if you qualify. NUA rules allow you to take employer stock out of your 401(k) upon certain triggering events, only pay ordinary income taxes on the cost basis of the stock (the price you originally paid for the stock) for the withdrawal, and then have the gains taxed at capital gains tax rates. This can be particularly valuable if: 

• You have highly appreciated employer stock (stock with very low-cost basis);  
• You have an immediate need to withdraw money from your 401(k);  
• You are retiring after age 70.5 and you have to take your first required minimum distribution (RMD); or  
• You have a short RMD period, including stretch RMDs. 

The rules for an NUA distribution are very strict, and you should work with your CPA to make sure you follow all the rules precisely. The rules are as follows: 

• You have to distribute the entire balance of your 401(k) and any other qualified plans you have with the employer in a single tax year (some can be withdrawn directly to a taxable account and some can be rolled into an IRA, but there can be no money left in your 401(k) account at the end of the tax year).  
• You must take the distribution of company stock from your 401(k) in actual shares—you cannot sell the shares in the 401(k) and then distribute cash.  
• You must have experienced one of the following triggering events: 
• Separation from service from the company whose plan holds the stock (this may include certain cash buyouts of the company you work for);  
• Reached age 59.5; 
• Become disabled; or 
• Death 

CLASSIFICATION OF QUALIFIED PLANS

There are two broad classifications of qualified plans. The first classification differentiates between pension plans and profit-sharing plans and the second between defined-benefit and defined-contribution plans. These broad classifications are useful in identifying plans that meet broad overall goals of the employee. Once detailed employer objectives have been determined, a specific qualified plan program can be developed for the employer using one or more of the types of plans from a menu of specific plan types. The specific plan types contain a lot of flexibility in design to meet employer needs, and one or more different plans or plan types can be designed covering the same or overlapping groups of employees to provide the exact type of benefits that the employer desires.

Pension and Profit-Sharing Plans

One way of broadly classifying qualified plans is to distinguish between pension plans and profit-sharing plans. A pension plan is a plan designed primarily to provide income at retirement. Thus, benefits are generally not available from a pension plan until the employee reaches a specified age, referred to as the normal retirement age. Some plans also provide an optional benefit at an earlier age (the early retirement age). The design of a pension plan benefit formula must be such that an employee's retirement benefit is reasonably predictable in advance. Because the object of a pension plan is to provide retirement security, the employer must keep the fund at an adequate level. Pension plans are subject to the minimum funding rules of the Code, and these generally require that the employer make regular deposits to avoid a penalty.

By contrast, a profit-sharing plan is designed to allow a relatively short-term deferral of income; it is a somewhat more speculative benefit to the employee because the employer's contribution can be based on profits. Furthermore, a profit-sharing plan can provide for a totally discretionary employer contribution so that even if the employer has profits in a given year, the employer need not make a contribution for that year. The minimum funding rules do not apply. However, there must be substantial and recurring contributions or the plan will be deemed to be terminated.

In a profit-sharing plan, it is difficult to determine the employee's benefit in advance, and the plan is considered more an incentive to employees than a predictable source of retirement income. Because it is not exclusively designed for retirement income, employees may be permitted to withdraw funds from the plan before retirement. The plan may allow amounts to be withdrawn as early as two years after the employer has contributed them to the plan. However, as with any qualified plan, preretirement withdrawals may be subject to a 10 percent penalty. Finally, the deductible annual employer contribution is limited to 15 percent of payroll, an amount less than would usually be deductible under a pension plan.

Defined-Benefit and Defined-Contribution Plans

Qualified plans are also divided into defined-benefit and defined-contribution plans. A defined-contribution plan has an individual account for each employee; defined-contribution plans are, therefore, sometimes referred to as individual-account plans. The plan document describes the amount the employer will contribute to the plan, but it does not promise any particular benefit. When the plan participant retires or otherwise becomes eligible for benefits under the plan, the benefit will be the total amount in the participant's account, including past investment earnings on the amounts put into the account. The participant can look only to his or her own account to recover benefits; he or she is not entitled to amounts in any other account. Thus, the participant bears the risk of bad plan investments.

In a defined-benefit plan the plan document specifies the amount of benefit promised to the employee at normal retirement age. The plan itself does not specify the amount the employer must contribute annually to the plan. The plan's actuary will determine the annual contribution required so that the plan fund will be sufficient to pay the promised benefit as each participant retires. If the fund is inadequate, the employer is responsible for making additional contributions. There are no individual participant accounts, and each participant has a claim on the entire fund for the defined benefit. Because of the actuarial aspects, defined-benefit plans tend to be more complicated and expensive to administer than defined-contribution plans.

Specific Types of Qualified Plans

As Figure 1 indicates, within the broad categories (pension, profit-sharing, defined-benefit, defined-contribution), there are specific types of plans available to meet various retirement-planning objectives.

Figure 1: Types of Qualified Plans

Defined-Benefit Pension Plan

All defined-benefit plans are pension plans; they are designed primarily to provide income at retirement. A defined-benefit plan specifies the benefit in terms of a formula, of which there are many different types. Such formulas may state the benefit in terms of a percentage of earnings measured over a specific period of time, and might also be based on years of service. For example, a defined-benefit plan might promise a monthly retirement benefit equal to 50 percent of the employee's average monthly earnings over the five years prior to retirement. Or instead of a flat 50 percent, the plan might provide something like 1.5 percent for each of the employee's years of service, with the resulting percentage applied to the employee's earnings averaged over a stated period. Employer contributions to the plan are determined actuarially. Thus, for a given benefit, a defined-benefit plan will tend to result in a larger employer contribution on behalf of employees who enter the plan at older ages, because there is less time to fund the benefit for them.

Cash-Balance Pension Plan

In a cash-balance plan (also called a guaranteed account plan and various other titles), each participant has an "account" that increases annually as a result of two types of credits: a compensation credit, based on the participant's compensation, and an interest credit equal to a guaranteed rate of interest. As a result of the guarantee, the participant does not bear the investment risk. Unlike defined-benefit formulas, the plan deposits are not based on age, and younger employees receive the same benefit accrual as those hired at older ages. The plan is funded by the employer on an actuarial basis; the plan fund's actual rate of investment return may be more or less than the guaranteed rate, and employer deposits are adjusted accordingly. Technically, because of the guaranteed minimum benefit, the plan is treated as a defined-benefit plan. From the participant's viewpoint, however, the plan appears very similar to a money-purchase plan, described below.

Target-Benefit Pension Plan

A target plan uses a benefit formula (the "target") like that of a defined-benefit plan. However, a target plan is a defined-contribution plan and, therefore, the benefit consists solely of the amount in each employee's individual account at retirement. Initial contributions to a target plan are determined actuarially, but the employer does not guarantee that the benefit will meet the target level, so the initial contribution level is not adjusted to reflect actuarial experience. Like a defined-benefit plan, a target-benefit plan provides a relatively higher contribution on behalf of employees entering the plan at older ages.

Money-Purchase Pension Plan

A money-purchase pension plan is a defined-contribution plan that is in some ways the simplest form of qualified plan. The plan simply specifies a level of contribution to each participant's individual account. For example, the plan might specify that the employer will contribute each year to each participant's account an amount equal to 10 percent of that participant's compensation for the year. The participant's retirement benefit is equal to the amount in the account at retirement. Thus, the account reflects not only the initial contribution level but also any subsequent favorable or unfavorable investment results obtained by the plan fund. The term money purchase arose because in many such plans, the amount in the participant's account at retirement is not distributed in a lump sum but rather is used to purchase a single or joint life annuity for the participant.

Profit-Sharing Plan

As described earlier, the significant features of a profit-sharing plan are that employer contributions are, within limits, discretionary on the part of the employer and that employee withdrawals before retirement may be permitted. Profit-sharing plans that are designed to allow employee contributions are sometimes referred to as savings or thrift plans.

Section 401(k) Plan

A Section 401(k) plan, also called a cash or deferred plan, is a plan allowing employees to choose (within limits) to receive compensation either as current cash or as a contribution to a qualified profit-sharing plan. The amount contributed to the plan is not currently taxable to the employee. Such plans have become popular because of their flexibility and tax advantages. However, such plans must include restrictions that may be burdensome to the employer or the employees. The most significant restrictions are a requirement of immediate vesting for amounts contributed under the employee election and restrictions on distribution of these amounts to employees prior to age 59½.

Stock Bonus Plan

The stock bonus plan resembles a profit-sharing plan except that employer contributions are in the form of employer stock rather than cash and the plan fund consists primarily of employer stock.

The fiduciary requirements of the pension law forbid an employer to invest more than 10 percent of a pension plan fund in stock of the employer company. This prevents the employer from utilizing pension plan funds primarily for financing the business rather than providing retirement security for employees. However, the 10 percent restriction does not apply to profit-sharing or stock bonus plans.

Stock bonus plans are intended specifically to give employees an ownership interest in the company at relatively low cost to the company. Stock bonus plans are also used by closely held companies to help create a market for stock of the employer.

ESOP

Employee stock ownership plans (ESOPs) are similar to stock bonus plans in that most or all of the plan fund consists of employer stock: employee accounts are stated in shares of employer stock. However, ESOPs are designed to offer a further benefit: the employer can use an ESOP as a mechanism for financing the business through borrowing or "leveraging." Various tax incentives exist to encourage this.