IRA Critical Mistake #6

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

1. Do you own stock of the company you work for inside your 401k?
   
   
2. Has your 401k employer stock sharply declined in price?
   
   

If your answer to both questions is yes, there’s a strong chance you could make IRA Critical Mistake #6 in THE IRA CRITICAL MISTAKES series.

How so? Read on!

After a sharp decline in the price of the employer stock inside your 401k, IRA Critical Mistake #6 is failing to consider selling the employer stock within the plan, then repurchasing it right away, to potentially lower the cost basis.

The lower the cost basis of your 401k employer stock, the more likely the stock will become 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 don’t consider selling your 401k employer stock after a sharp decline, you might 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 selling 401k employer stock.

The case study below shows the impact of selling 401k employer stock before these specific steps are taken.

• The value of your 401k employer stock is $1,000,000
  
  
• Your ordinary income tax rate is 37%
  
  
• Your long-term capital gains tax rate is 20%
  
  
• You sell your 401k employer stock
  
  

If you subsequently withdraw the $1,000,000 from your 401k, and are 59 ½ or older, the entire withdrawal would be taxed at the higher ordinary income tax rate of 37%, 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.

1. Implement the NUA strategy by following these steps:Implement the NUA strategy by following these steps:
   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: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.

The Net Unrealized Appreciation strategy works best when your 401k employer stock is highly appreciated.  This happens when the cost basis of your 401k employer shares is low and the market value is high, as in our example above of a $100,000 cost basis, $1,000,000 market value, and $900,000 gain.

In the event of a sharp decline in the price of the employer stock in your 401k, it may be beneficial to consider selling the stock within the 401k plan and then repurchase it right away. Fortunately, “wash sale” rules do not apply when the sale for a loss has occurred only inside your 401k.

The purpose of selling 401k company stock after a sharp decline in price and repurchasing it right away is to “reset” or potentially lower the cost basis of the stock.  

Be careful.  Sometimes selling 401k employer stock after a sharp decline will not lower your cost basis.

Let’s review two scenarios.

Scenario 1:

• Our example above shows the cost basis of the employer stock in your 401k is $100,000, the market value is $1,000,000, resulting in a gain or NUA of $900,000.
  
  
• Suppose the price of your 401k employer stock declined 50%, lowering your market value from $1,000,000 to $500,000.
  
  
• Would selling the employer stock within the plan and repurchasing it right away lower the cost basis? In this scenario, no.   Selling your $500,000 of 401k employer stock and repurchasing it for $500,000 would increase the cost basis from $100,000 to $500,000.
  
  
• In this scenario, because selling and repurchasing would increase your cost basis, it would likely not be to your advantage to sell and repurchase.
  
  

Scenario 2:

• Now assume the cost basis of the employer stock in your 401k is $100,000 and the market value is $150,000, resulting in a gain or NUA of $50,000.
  
  
• Suppose the price of your 401k employer stock declined 50%, lowering your market value from $150,000 to $75,000.  You have no gain or NUA, and instead have a $25,000 loss.
  
  
• Would selling the employer stock within the plan and repurchasing it right away lower the cost basis? In this scenario, yes.   Selling your $75,000 of 401k employer stock and repurchasing it for $75,000 would decrease the cost basis from $100,000 to $75,000.
  
  
• In this scenario, because selling and repurchasing would lower your cost basis, it may be to your advantage to sell and repurchase.
  
  

After a sharp decline, if you can lower the cost basis of your 401k employer stock, you might improve your ability to enjoy the special tax treatment of implementing the NUA strategy in the future if your 401k employer stock price later rises.

• Consult with your financial or tax advisor to determine if the employer stock in your 401k is a candidate for special tax treatment using the Net Unrealized Appreciation (NUA) strategy.• Consult with your financial or tax advisor to determine if the employer stock in your 401k is a candidate for special tax treatment using the Net Unrealized Appreciation (NUA) strategy.
  
  
• If the employer stock in your 401k has sharply declined in price, consider selling the stock within your plan and repurchase it right away if you are able to lower the cost basis.
  
  
• If the employer stock in your 401k has not sharply declined in price, someday, unfortunately, it could.  Be ready to know when, and when not, to sell and repurchase in the event of a future sharp decline.
  
  
• For more mistakes involving the NUA strategy, click below to access
  
  
  • IRA Critical Mistake #3:  Have Employer Stock in 401k? Do This Before Rollover to IRA
    
  • 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