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Rolling over a 401(k)? Consider Net Unrealized Appreciation

By Jane Kee

Taking Stock

As a general rule, moving 401(k) assets to an IRA when you retire or as an answer to a diversified and pragmatic fund investment strategy as you leave your employer – is a good idea. Taking advantage of continued tax-deferred savings may seem like the best way to go. Actually, this is not always the case. When a large chunk of your 401(k) funds lies in company stock, rolling that portion over may not be the most advantageous course.

Employer-sponsored plans weighted heavily with highly appreciated company stock may be prime for a special tax treatment called net unrealized appreciation (NUA). This strategy allows you to receive employer stock and pay current income tax on the average cost of the shares, rather than the current market value. The tax on the difference between the cost basis and the stock’s market value—also called NUA—will not be due until the stock is sold. When the shares are sold, the NUA on the stock will be taxed at the long-term capital gains rate, which is presently 20% for most people.

For Example…

Company stock was added to your 401(k) over the years and has grown to a sizable sum. You’re one of the lucky ones…the value of your stock has risen significantly. Averaging the purchase price per share of all the stock in your plan will give you the cost basis, which invariably comes out to be lower than the current market value. This is where the strategy of BUA comes into play.

Let’s use this example: You have 1,000 shares of company stock with a cost basis of $10 per share and a market value of $50 per share. Your tax bracket is 31%, which makes your capital gains rate 20%. Let’s calculate the tax implications of rolling your stock into an IRA versus moving it to a taxable account using NUA. (For this example, it is assumed that you are over

59 ½ and therefore will not be required to pay a 10% penalty for early distribution.)

Using NUA IRA Rollover

Cost basis = $10,000 Market value of stock = $50,000

Market value = $50,000 Taxes owed = 0

Taxes owed = $10,000 x .31 = $3,100 Total rolled into IRA = $50,000

It’s three years later. You’ve decided to sell all of your company stock, which has appreciated to $70 per share. You withdraw your funds as a lump sum. Here’s the math.

Using NUA IRA Rollover

Market value = $70,000* Value of stock = $70,000

NUA = $70,000 – $10,000 = $60,000 Taxes owed = $70,000 x .31 = $21,700

Taxes owed = $60,000 x .20 = $12,000

*It is assumed that the taxes owed as a result of transferring the stock to a taxable account were not paid from the stock itself.

Here’s the final analysis.

Using NUA IRA Rollover

Total taxes = $12,000 + $3,100 = $15,100 Total taxes = $21,700

NOTE: You are responsible for paying annual taxes on any dividends from stock held in a taxable account.

Questions to Consider when Using Net Unrealized Appreciation

· How long are you willing to hold the stock?

· Can you pay the taxes required for your method of distribution?

· Will you be over age 59 ½ when you receive your lump-sum distribution?

· Has your accountant calculated the taxes due using all the options available for net unrealized appreciation?

A Valuable Estate Planning Strategy

Another consideration is your beneficiaries. If your heirs inherit your stock after your death, the formula for net unrealized appreciation still applies—but with another particularly attractive benefit. When your heirs choose to sell the stock, they will be responsible for paying taxes only on the net unrealized appreciation the stock gained while in your employer’s plan. Any further gain realized on the stock after distribution from your plan will be paid out tax-free.

An IRA is a great way to preserve money. But the special tax rules of net unrealized appreciation can make it more profitable to keep company stock on the outside. In the long run, it may save you more.

Jane Kee is a Financial Consultant with Salomon Smith Barney. She can be reached at 201-368-4927 or 800-922-0899 ext. 4927. Salomon Smith Barney does not provide tax or legal advice. Please consult your tax and/or legal advisor for such guidance. All examples are for illustrative purposes only.


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