Choosing a Route for Your Company Stock

By Susan B. Garland

You've probably already heard about a tax break called net unrealized appreciation. It's often promoted as a great deal for anyone with appreciated company stock in a 401(k). But it's not right for everyone.

Although it sounds convoluted, the concept is simple. Let's say over the past few years you paid $20,000 in pretax dollars for your company's stock for your 401(k). Now you're about to retire, and the shares are worth $50,000. The $30,000 in increased value is the net unrealized appreciation, or NUA.

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If you roll the employer stock along with your other assets into an IRA, you'll owe no income tax now, but that appreciation -- along with all other IRA withdrawals -- will be taxed in your top tax bracket, as high as 35%. If instead you split off the company stock and stick it in a taxable account (while rolling the rest of your money into the IRA), you'll owe tax now, but only on the $20,000 you paid for the stock. When you sell the shares in the taxable account, the $30,000 of NUA will enjoy the 15% capital-gains rate. In the best-case scenario, shifting $30,000 from the 35% to the 15% rate would save you $6,000.

Compare the Options

Americans love tax breaks, and paying a lower capital-gains tax on the appreciation can save many retirees a lot of money. But a new Fidelity Research Institute analysis found that it often makes sense to forgo this tax break and stick the stock in the IRA.

In its analysis, Fidelity looked at a 65-year-old retiree with company stock worth $100,000. After moving the shares into either the IRA or the taxable account, the retiree sold the company stock and reinvested the proceeds in a diversified equities portfolio with an average return of 8.3%.

Fidelity concluded that for retirees who intend to hold on to the equities for ten years or more, it's better to decline the NUA tax break. Sure, you'll pay income tax when you withdraw that appreciation from your IRA. But the years of compounded tax-deferred growth of the money that would go to pay taxes if you went the NUA route outweigh the savings from the lower capital-gains tax.

If you need to spend the money within five years of retirement, you should probably move the company stock to a taxable account and pay tax on your basis up front. In that case, the lower tax on the appreciation portion would more than compensate for paying tax on the basis sooner rather than later.

"If you need to tap into your assets in the short term, to buy a boat or take a world cruise, then you're more likely to elect the NUA," says Steven Feinschreiber, the institute's senior vice-president. "If you're not going to spend the money for a long time, you're better off keeping the money in an IRA."

Consider these scenarios. All assume that an employee is in the 28% tax bracket in retirement and owned $100,000 of company stock with a net unrealized appreciation of 70% of the total market value.

Say the retiree elects the NUA and the shares are put in a taxable account. The stock is sold, and the retiree pays capital-gains tax on the $70,000 of appreciation and income tax on the rest. The retiree invests the proceeds in a diversified portfolio. If the retiree liquidates in five years, he or she will have $94,661, after paying taxes. That compares with $89,050 if the shares had been rolled into an IRA, then cashed out after five years at the ordinary income-tax rate. But if the retiree who takes the NUA keeps the shares for 25 years in a taxable account, the after-tax value will be $151,402. That compares with $169,813 if the shares are sold from an IRA.

Market conditions, one's tax bracket and other variables could affect the outcome, so check with a financial adviser before you make a decision. Also read Fidelity's study at www.fidelityresearchinstitute.com.

Whichever route you take, Fidelity warns that you shouldn't hold on to company stock indefinitely. As we said above, once you move the stock to the taxable account or the IRA, sell it and invest in the diversified portfolio. Feinschreiber notes that the volatility of holding stock in a single company will hamper the returns of any portfolio.