Own Company Stock Inside Your 401(k)? Here’s Something to Be Aware Of
These days, companies must get creative about the ways in which they both compensate and motivate their workforce. One of the most popular practices is to offer employees opportunities to own company stock, essentially helping them take ownership of their work performance, whether good or bad. And one of the more popular ways companies support employee ownership of that stock is by allowing them to purchase shares through their 401(k) plan.
In some instances, employees are able to accumulate a sizeable sum of those shares and defer taxes on any growth in the process. But what happens to those shares when it is time to part ways?
Typically, when employees leave a company where they have contributed to a retirement plan, it is customary to roll that 401(k) balance either into their new company’s plan or into an individual retirement account (IRA). Among other reasons, rolling over 401(k) money provides a great way to continue deferring taxes on the account's earnings until you retire and begin taking distributions.
However, for those who own a significant amount of their company’s stock within their 401(k), it is important to know what to do with that stock prior to making any moves. If stock owned inside the former company’s plan has appreciated any, the decision of if and how to execute a rollover is not so straightforward. While it is likely that you are prohibited from rolling that appreciated company stock into your new company’s plan, it could also be a bad idea to roll these shares over to an IRA.
A change in employment can provide you with an opportunity to move the stock to a brokerage account, immediately pay the applicable taxes due, and subsequently receive more favorable tax treatment on any gains in that stock in the long run. The difference between the stock's value when acquired and its current value, known as its net unrealized appreciation (NUA), would then be subject only to capital gains tax rather than the more costly ordinary income tax. This is why moving company stock to a brokerage account as opposed to rolling it into another tax-deferred retirement account could be the preferred option.
In other words, how that appreciation in the stock's value is ultimately taxed will depend on the type of account the stock is transferred to when it leaves your 401(k). If the transfer is to an IRA, the full account balance will remain deferred from taxes until you take a distribution. And while tax deferral is certainly helpful, it is important to be aware of the inherent tradeoff that you will ultimately be making. In this instance, you will have to pay ordinary income tax on the stock's full appreciated value once you sell it to take a distribution in the future.
Even if your plan is to sell appreciated shares immediately after separating from your employer, there is still an advantage to rolling those shares to a brokerage account first. As of the time of this writing, stocks are required to be held for at least a full year to receive long-term capital gains treatment rather than as ordinary income. However, this is not the case with stock transferred directly from your 401(k) to a brokerage account.
Example:
Let’s say Elizabeth is an employee at Apple, and has been at the company for 20 years. She is planning to leave at the end of the month to take a new role at a competitor, and she has accumulated $500,000 worth of Apple stock inside her 401(k) plan (mostly from long-term appreciation). However, her basis in the stock is only $50,000.
If Elizabeth were to roll her entire 401(k) balance (including the shares of Apple) into either a traditional IRA or her new company’s 401(k) plan, her entire position would be liquidated, and she would receive a cash deposit into the new account. Then, whenever Elizabeth retires, she would pay ordinary income taxes on any portion of her tax-deferred retirement account balance that she distributed.
However, if Elizabeth executed an NUA transaction, she would “roll” the shares of Apple stock from the 401(k) plan into a taxable brokerage account. The $50,000 cost basis of the stock would be taxed as ordinary income in the year of the distribution. However, the $450,000 NUA would not be taxed until Elizabeth sells the stock in the taxable account. When sold, the NUA would be subject to long-term capital gains tax, which could be as low as 0%, 15%, or 20%, depending on Elizabeth’s overall taxable income at the time.
Beyond the short-to-intermediate-term advantages of opting to pay the taxes on the NUA today, there are longer term estate planning advantages as well. At the time of this writing, if the stock in your brokerage account is left to an heir instead of being sold during your lifetime, that inheritor would receive a step up in cost basis and avoid paying capital gains taxes on those appreciated shares from the point at which you acquired them.
If you were to pass away while still holding employer stock in your 401(k) plan, it is also important for your named beneficiaries to know that they would be eligible to request a lump sum distribution and apply that same NUA tax treatment to any portion held in the former company’s stock. In that instance, your beneficiaries would not receive a step up in basis. They would, however, still receive the same favorable tax treatment as if you had taken the distribution yourself. It is important to note that this preferred tax treatment does not apply to any further appreciation in the stock after it is transferred out of your 401(k).
It is also important to point out that while owning your company’s stock inside your 401(k) account certainly has its advantages, it can also pose substantial risks to employees who become too confident in the company’s growth potential and rack up too much of that stock. While case studies like Enron and Lehman Brothers — whose employees got burned by holding too much company stock in their 401(k) plans — have certainly made people more aware of the risks of concentrated stock positions, these risks are not always explained adequately to plan participants.
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Malcolm Ethridge, CFP®, CRPC® is an Executive Vice President and fiduciary Financial Advisor with CIC Wealth, based in the Washington, DC area. For more information or to schedule a consultation with Malcolm, click here.
Malcolm’s areas of expertise include retirement planning, investment portfolio development, insurance, equity compensation and other executive benefits. To subscribe to Malcolm’s monthly newsletter and receive more content like this, click here.
Disclosures:
CIC Wealth, LLC does not provide legal or tax advice. Be sure to consult with your tax and legal advisors before taking any action that could have tax consequences.
Investments in securities and insurance products are: NOT FDIC-INSURED | NOT BANK-GUARANTEED | MAY LOSE VALUE