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 

Employee Stock Ownership Plan (ESOP)

The ESOP is a stock bonus plan with an important additional feature: If certain requirements are met, the plan can be used by the employer company as a means of raising funds on a tax-favored basis. The funds can be used for any corporate purposes, which can include acquiring the assets or stock of another company.

In effect, an ESOP allows an employer to indirectly borrow money from a bank and repay the loan with fully deductible repayment amounts. The repayment amounts are deductible in full because they are structured as contributions to an ESOP; normally, only the interest portion of a loan repayment would be tax deductible.

This bit of tax magic (see Figure1) is accomplished by first having the plan trustee borrow money from a bank or other lender. The borrowed money is then used to purchase a block of employer stock from the employer. Shares of this stock also will subsequently be allocated to participants' accounts in the ESOP as plan contributions are made. The employer makes periodic plan contributions to the ESOP and obtains a tax deduction for them. These plan contributions are designed to be enough to enable the plan trustee to gradually repay the loan to the bank. The net result is that the employer immediately receives the full proceeds of the bank loan and in effect pays off the loan through tax-deductible contributions to the plan on behalf of plan participants.

Figure1

Because the ESOP normally has no financial status independent of the employer, the employer usually must guarantee the loan to the bank. If the plan gives collateral for the loan, the collateral may consist only of qualifying employer securities.

Contribution Formulas and Accounts

An ESOP's contribution allocation formula may not be integrated with Social Security because plan allocations must be based on total compensation. In other respects, contribution formulas and participants' accounts are handled in the same manner as for the stock bonus plan described earlier.

Deductibility of Contributions

The rules for contribution deductibility for an ESOP are somewhat different from those for a stock bonus plan or profit-sharing plan. If employer contributions to the ESOP are applied to the repayment of a loan, amounts applied by the plan to repay the loan principal are deductible by the employer up to a limit of 25 percent of compensation of employees covered under the plan. Amounts used to repay interest are deductible without any percentage limit.

Plan Distributions

The distribution rules, voting rights, and taxation considerations regarding ESOP distributions are the same as those discussed earlier in connection with stock bonus plans.

Diversification Requirement

To reduce investment risks, participants in ESOPs who have reached age 55 with ten years of service are entitled to an annual election requiring the employer to diversify investment in the participant's account. The plan must offer at least three investment options, other than employer stock, to the participant for diversification purposes.

Creating a Market for Closely Held Stock

In small companies, it is often important for shareholders to find a market for their stock for financial and estate planning purposes. Many types of plans have been designed to enable the use of company funds for purchasing stock, such as stock redemption and corporate-owned life insurance plans. An ESOP or stock bonus plan can also be helpful for this purpose. The shareholder can sell stock to the plan during lifetime or at death, generally with favorable tax results. These techniques involve various complexities and must be designed with some care.