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 

INCENTIVE STOCK OPTIONS

The incentive stock option (ISO) is the current form of stock option plan eligible for special tax benefits, which are provided by Code Section 422. Under an ISO plan, the usual tax rules previously discussed do not apply. Instead, for stock purchased under an ISO plan, there is no taxation to the employee until the stock is sold. Employees do not realize any taxable income when they receive the option, even if the option has an ascertainable fair market value and, furthermore, there is no taxable income when the option is exercised. However, the difference between the option price and the fair market value at the time of exercise is a tax preference item that may be subject to the alternative minimum tax. Because there is no regular taxable income to the employee at either the grant or the exercise of the option, the corporation gets no deduction at any time.

Options under an ISO plan must generally be granted to employees within ten years of the plan's adoption or approval by the shareholders, and an option must be exercised by the employee within ten years after it is granted. The option price must equal or exceed the stock's fair market value at the time the option is granted. Any good-faith attempt to value stock will be acceptable if there is no readily established market.

ISO plans increase the tax benefit of stock options as a form of compensation by providing increased tax deferral and, therefore, represent an attractive executive benefit. However, they are most likely to be used in large corporations. If an option holder has stock with more than 10 percent of the total combined voting power of the employer corporation, taking certain stock attribution rules into account, there are additional restrictions on ISO plans that may make them unattractive for closely held corporations. In such cases, the option price must be at least 110 percent of the stock's fair market value at the time it is granted and the option must be exercised within five years after it is granted rather than ten. Also, an employee receives the maximum tax benefit from an ISO plan only when the stock is sold, and there may be no ready market for a stock of a closely held corporation. Furthermore, it may be undesirable to pass ownership of stock in a closely held corporation to outsiders. However, the plan may permit the employee to exercise an option and pay for the shares of stock with other stock of the employer.

The aggregate fair market value of stock for which an employee can be granted an option under an ISO plan during a single calendar year cannot exceed $100,000. There are carryover provisions if the employee does not use the full limit in any year.