The Dangers of Rolling Your Company Stock into an IRA |
| FEBRUARY 22, 2012 |
The Dow Jones Industrial Average is approaching its all-time high of 14,000.
Eventually it will reach a new high, rewarding those investors that were
patient and especially those that continued to invest during the downturn.
Investors that added money to their company 401(k) and in particular
bought their company stock while it was low have an added tax advantage
that they need to keep in mind when retiring.
The best way to explain this technique is to tell you the story of Rodney
Hartwell, whose stock distributions from his tax-deferred retirement plan
weren’t structured in the most tax-efficient way possible:
Case Study: Rodney Hartwell, medical supply executive
Rodney Hartwell, an executive at a medical supply company, was
planning on retiring at year-end. Rodney had $100,000 worth of
employer’s stock held in the company’s 401(k) plan with a cost basis
of $20,000. A local investment advisor recommended Rodney roll his
company stock into a low-cost IRA, explaining the advantages of the IRA
and telling Rodney his account would grow larger because the tax would
be deferred—and there was also the likelihood of potential returns with
the hot mutual fund he just happened to be recommending for the IRA.
The advice this investment advisor gave to Rodney wasn’t unusual, since
tax-deferred savings accounts are most people’s go-to method of saving
for retirement. But as I mentioned in my book “The New Three Legged
Stool”, the major problem with this scenario is every dollar a retiree
wants to spend is going to be taxable when he or she reaches for it.
The advisor likely failed to explain the downside of this unfortunate fact
to Rodney, and so when his IRA eventually began to distribute income,
that income was taxed at ordinary income rates on his $20,000 cost basis
and could eventually have been taxed even higher (35%) on his $80,000
gain.
The advisor should have recommended Rodney use an often-overlooked
tax strategy known as net unrealized appreciation (NUA). How does an NUA
work? Here’s an example. An employee is about to retire and qualifies for
a lump sum distribution from a qualified retirement plan. He elects to use
the NUA strategy, receives the stock, and pays ordinary income tax on the
average cost basis, which represents the original cost of the shares. This
strategy allows the tax to be deferred on any appreciation that accrues from
the time the stock is distributed until it’s finally sold.
Note the NUA distribution must be taken as a lump sum distribution, not
a partial lump sum distribution, and in order to qualify for a lump sum
distribution, the employee must take the distribution all within the same
calendar year.
The NUA strategy would have allowed Rodney to receive an in-kind
distribution of his company’s stock and pay income tax only on the average
cost basis of the shares, rather than on the current market value. In that
case, Hartwell’s tax on the $80,000 gain would be treated as long-term
capital gains and taxed at a maximum of 15%, resulting in a potential
tax savings of $12,000. (Of course, the $20,000 basis would be taxed as
ordinary income.)
Five Steps to a Successful NUA Transaction
Before exercising a distribution or rollover, follow these five steps designed
to help you understand what it takes to complete a successful NUA
transaction.
- Start early—the NUA transaction may take several weeks. Make sure you
obtain a written copy of your cost basis before initiating the rollover. You
can get formal documentation of the cost basis of the company stock; you
can also request formal documentation showing your employer’s promise to
make an in-kind distribution of the company shares.
- Determine the amount of gain in the stock price. In an employer-
sponsored retirement plan, you can elect an NUA on some, all, or none of
the shares. Note, however, on shares you bought for more than the current
stock price, it’s not logical to elect this strategy. Instead, seek out shares
that are currently selling for twice your cost basis.
- Select the sequence of transactions when the plan holds other assets
in addition to employer securities. You can transfer the company stock
portion (which still qualifies for the tax break on the NUA) to a taxable
(non-IRA) brokerage account, and you can roll the non-company stock
portion of the plan into an IRA rollover account. You should execute the IRA
rollover first for all assets except the company stock, then the NUA shares
can be distributed in-kind, with nothing to withhold for the IRS from either
transaction. Note that unless it’s a trustee-to-trustee transfer, or the only
remaining asset being distributed is employer stock, your employer should
withhold 20% of distributions from a qualified plan for taxes.
- Know Your Liabilities. You should have your tax professional prepare a tax projection to determine the amount needed, and be prepared to pay the tax
man in April.
- Prepare an exit strategy. Assuming you’re optimistic about your
company’s future and proceed with the in-kind distribution, you should still
have an exit strategy if the stock starts to decline. One possibility would be
to give some or all of the stock to a charitable remainder unitrust (CRUT).
Once the stock is transferred to a CRUT, the shares can be sold by the
trustee and reinvested in a diversified portfolio that can provide lifelong
income to the donor. The charitable deduction might even offset most of the
tax obligation on the cost basis.
A few words of caution before you jump on the NUA bandwagon: first, an
NUA distribution may not be a good idea if the company’s outlook is bleak.
The tax benefits are wasted if the company stock declines significantly after
the distribution. An investor with 98% of his retirement account tied up in
one stock may want to consider liquidating a portion of his stock position
and distributing a smaller portion of the stock in-kind. Second, never ask for
in-kind distributions of company stock in December. It’s better to wait until
the beginning of the next year because the entire distribution (rollover and
in-kind distribution) must be completed in the same calendar year.
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Rodgers & Associates is a wealth management firm specializing in all aspects of investment, tax, risk management, and estate planning for high net-worth individuals in or near retirement. |
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Rick Rodgers is one of America's leading retirement planning experts and author of The New Three Legged Stool. He has been featured in the New York Times, Smart Money magazine, FOX Business and The 700 Club, among many other TV shows and publications. He is the founder and CEO of Rodgers & Associates.
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- If you own large quantities of company stock inside a retirement plan,
you should know about Net Unrealized Appreciation (NUA).
- NUA allows the tax to be deferred on any appreciation that accrues
from the time the stock is distributed until it’s finally sold.
- Distributions must be taken as lump sum distributions, not partial
lump sum distributions.
- In order to qualify for the NUA treatment, an employee must complete
the entire distribution within the same calendar year.
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