IRA Critical Mistake #3

You’ve been very careful with your 401k and IRA. You thought you did everything right.  But ask yourself three questions:

1. Do you own stock of the company you work for inside your 401k?
   
   
2. Is your 401k employer stock highly appreciated?
   
   
3. At retirement, or when you leave your company, do you plan to roll over your 401k to an IRA?
   
   

If your answer to all three questions is yes, there is a strong chance you will make IRA Critical Mistake #3 in the IRA CRITICAL MISTAKES series.

How so? Read on!

IRA Critical Mistake #3 is rolling over your 401k to an IRA before you have evaluated if the highly appreciated employer stock in your 401k is eligible for special tax treatment that could potentially save you a lot of money in taxes.

Why is this a mistake? What do you risk losing if you make this mistake?

If you are a candidate for the special tax treatment, and you roll over your 401k to an IRA, you will likely forfeit the ability to receive this special tax treatment that could allow a portion of your 401k employer stock to be taxed at a much lower rate.

To preserve the ability to receive this special tax treatment, specific steps must be followed before the 401k can be rolled over to your IRA.

The case study below shows the impact of rolling over a 401k to an IRA before these specific steps are taken.

• Your 401k value is $1,000,000, which includes the value of your employer stock.
  
  
• Your ordinary income tax rate is 37%
  
  
• Your long-term capital gains tax rate is 20%
  
  
• You roll over your 401k containing employer stock to an IRA
  
  

If you are at least age 59 ½, withdrawals from your IRA will be taxed at the higher “ordinary income” tax rate.  For example, if you distribute $1,000,000 from your IRA, you’ll pay the ordinary income tax rate of 37% on $1,000,000, or $370,000.  That’s a lot of tax.

Is it possible for a portion of the employer stock in your 401k to be taxed someday at the lower 20% long-term capital gains rate rather than the higher 37% ordinary income tax rate?

Yes, it is! The strategy to accomplish this feat is a little-known provision in the tax code called “Net Unrealized Appreciation (NUA)”.

It works like this.

Assume you purchase $100,000 of employer stock in your 401k. This $100,000 is called your “cost basis”. Assume your $100,000 of employer stock grows in value to $1,000,000, meaning a gain of $900,000. Inside a 401k, this gain is called “Net Unrealized Appreciation”. Net Unrealized Appreciation is a tax break that allows a portion of your 401k employer stock to be taxed at the lower long-term capital gains tax rate rather than the higher ordinary income tax rate.

Implement the NUA strategy by following these steps:

1. Confirm you’re eligible for NUA if one of the four following “triggering” events have occurred:
   
   

   1. Reach age 59 ½
   2. Separation from service 
   3. Death
   4. Disability

2. Transfer all 401k non-employer stock holdings to an outside IRA via direct rollover.  The direct rollover avoids the 20% mandatory tax withholding.
   
   
3. Instruct your 401k to transfer the shares of your employer stock in certificate form to an outside taxable brokerage account (not to your IRA).
   
   
4. Confirm your transactions qualify as a “lump sum distribution”.
    
5. Ensure the value of your 401k is $0 on December 31 of the year you implement the NUA strategy.
   
   
6. Because successfully processing the NUA strategy is complex, consult with your financial or tax advisor from the beginning of the planning phase through execution. 

After your outside taxable brokerage account receives the employer stock from your 401k:

• You will pay the ordinary income tax rate on your “cost basis” of $100,000, which, in this example, is 37% of $100,000, or $37,000. If you are under age 59 ½ you might also trigger the 10% IRS penalty for early withdrawal on $100,000, or $10,000.
  
  
• You are free to sell your employer stock.  When you sell, your Net Unrealized Appreciation will receive the favorable long-term capital gains tax treatment, rather than the higher ordinary income tax treatment. You’ll also pay additional capital gains taxes on gains that occur after your taxable account receives the employer stock from your 401k.  The additional gains that occur after the date you distribute your NUA shares from the 401k will be taxable at short-term capital gain rates if the shares are sold in the first year after distribution. After one year, these additional gains would be taxed at long-term capital gains rates.
  
  
• In this example using the NUA strategy, if you sell all your employer stock, you’d trigger a 20% tax on the $900,000 NUA, or $180,000.  Adding this $180,000 tax to the $37,000 tax on the cost basis means you’d pay a total tax of $217,000 using the NUA strategy.  
  
  
• By contrast, as stated earlier, if you roll over your $1,000,000 401k to an IRA, and then distribute the entire amount, you’ll pay the 37% ordinary income tax on $1,000,000, or $370,000.
  
  
• To summarize this example, using the NUA strategy results in a $217,000 tax while not using the NUA strategy triggers a much higher $370,000 tax.
  
  
• Although you’ll pay ordinary income taxes on the cost basis of your employer stock when you receive it from your 401k, you will not trigger the long-term capital gains tax on the NUA until you sell your shares.  Therefore, if you don’t sell your employer stock, you won’t trigger the capital gains tax.

To receive the special tax treatment, the employer stock in your 401k cannot be rolled over to an IRA.

If you are a candidate for Net Unrealized Appreciation, and you roll over your 401k to an IRA, the opportunity for the special tax treatment may be lost.

• Before rolling over your 401k to an IRA, consult with your financial or tax advisor to determine if you are a candidate for the Net Unrealized Appreciation (NUA) strategy.  • Before rolling over your 401k to an IRA, consult with your financial or tax advisor to determine if you are a candidate for the Net Unrealized Appreciation (NUA) strategy.
  
  
• It is quite easy to unknowingly take actions that will disqualify you from being eligible to implement the NUA strategy.  Therefore, discuss with your financial or tax advisor the additional steps you must take to avoid disqualifying yourself from implementing the NUA strategy.
  
  
• For more mistakes involving the NUA strategy, click below to access
  
  
  • IRA Critical Mistake #4:  Have Employer Stock in 401k? Do This Before Selling Shares  
  • IRA Critical Mistake #5:  Have Employer Stock in 401k? Do This Before Withdrawing Funds
  • IRA Critical Mistake #6:  Have Employer Stock in 401k? Do This if Stock Sharply Declines