All investing involves risk, including the loss of principal. This discussion explains the tax treatment that may be available when employer stock is held in a qualified retirement plan. While the examples used in the discussion show such stock increasing in value over time, it is important to understand that any shares of stock held in a retirement plan, including shares of employer stock, can lose some or all of their value over time.
If you're expecting a distribution of employer securities from a qualified retirement plan, make sure you speak with your financial or tax professional before you take any action so that you can fully explore and understand all the options available to you. Only then can you be assured of making the decision that best meets your individual tax and nontax goals.
Net Unrealized Appreciation and Other Special Tax Rules
If you participate in a 401(k), ESOP, or other qualified retirement plan that lets you invest in your employer's stock, you need to know about net unrealized appreciation--a simple tax deferral opportunity with an unfortunately complicated name.
When you receive a distribution from your employer's retirement plan, the distribution is generally taxable to you at ordinary income tax rates. A common way of avoiding immediate taxation is to make a tax-free rollover to a traditional IRA. However, when you ultimately receive distributions from the IRA, they'll also be taxed at ordinary income tax rates. (Special rules apply to Roth and other after-tax contributions that are generally tax free when distributed.)
But if your distribution includes employer stock (or other employer securities), you may have another option--you may be able to defer paying tax on the portion of your distribution that represents net unrealized appreciation (NUA). You won't be taxed on the NUA until you sell the stock. What's more, the NUA will be taxed at long-term capital gains rates-- typically much lower than ordinary income tax rates. This strategy can often result in significant tax savings.
|NUA at a glance|
You receive a lump-sum distribution from your 401(k) plan consisting of $500,000 of employer stock. The cost basis is $50,000. You sell the stock 10 years later for $750,000.*
|Tax payable at distribution--stock valued at $500,000|
Taxed at ordinary income rates; 10% early payment penalty tax if you're not 55 or disabled
Tax deferred until sale of stock
|Tax payable at sale--stock valued at $750,000|
Already taxed at distribution; not taxed again at sale
Taxed at long-term capital gains rates regardless of holding period
Taxed as long- or short-term capital gain, depending on holding period outside plan (long-term in this example)
|*Assumes stock is attributable to your pretax and employer contributions and not after-tax contributions|
What is net unrealized appreciation?
A distribution of employer stock consists of two parts: (1) the cost basis (that is, the value of the stock when it was contributed to, or purchased by, your plan) and (2) any increase in value over the cost basis until the date the stock is distributed to you. This increase in value over basis, fixed at the time the stock is distributed in-kind to you, is the NUA.
For example, assume you retire and receive a distribution of employer stock worth $500,000 from your 401(k) plan, and that the cost basis in the stock is $50,000. The $450,000 gain is NUA.
How does the NUA tax strategy work?
At the time you receive a lump-sum distribution that includes employer stock, you'll pay ordinary income tax only on the cost basis in the employer securities. You won't pay any tax on the NUA until you sell the securities. At that time the NUA is taxed at long-term capital gain rates, no matter how long you've held the securities outside of the plan (even if only for a single day). Any appreciation at the time of sale in excess of your NUA is taxed as either short-term or long-term capital gain, depending on how long you've held the stock outside the plan.
Using the example in the chart above, you would pay ordinary income tax on $50,000, the cost basis, when you receive your lump-sum distribution. (You may also be subject to a 10% early distribution penalty if you're not age 55 or disabled when you receive the payment.) Let's say you sell the stock after ten years, when it's worth $750,000. At that time, you'll pay long-term capital gains tax on your NUA ($450,000). You'll also pay long-term capital gains tax on the additional appreciation ($250,000), since you held the stock for more than one year. Note that since you've already paid tax on the $50,000 cost basis, you won't pay tax on that amount again when you sell the stock.
If your distribution includes cash in addition to the stock, you can either roll the cash over to an IRA or take it as a taxable distribution. And you don't have to use the NUA strategy for all of your employer stock-- you can roll a portion over to an IRA and apply NUA tax treatment to the rest.