The Special Plan That Saves Taxes on Retirement Plan Concentrated Stock Positions

In the July 2021 issue of On Course, different strategies are covered for diversifying out of a concentrated stock position when those assets are held in a taxable account. Some people, however, end up with large amounts of employer stock in their company retirement plan, whether a 401(k) or an Employee Stock Ownership Plan (ESOP).

While taxes are not owed while the stock is in the plan, any distributions become subject to ordinary income tax. Yet many people don’t realize that a special strategy exists that allows taxes to be paid at the preferential capital gains rate. It’s called the Net Unrealized Appreciation (NUA) tax treatment.

Several paths can lead to this tax strategy. Some companies allow employees to invest in the company stock. Or, perhaps, the 401(k) match is provided in stock shares instead of cash. Over the years, the shares continue to grow in price and, eventually, a significant holding of stock is owned.

Normally it’s advisable to diversify out of a concentrated position in a retirement account immediately since there are no tax consequences to making the move and doing so reduces risk. But when employer stock is involved, and the client is getting close to retirement, the NUA strategy may make more sense.

A quick note: many people remember the days when you were prohibited or strongly discouraged from selling your employer’s stock in a 401(k). After the Enron meltdown, Congress passed the Pension Protection Act in 2006 that ended such restrictions.

As an example, let’s say you are a couple of years away from retirement and have $500,000 in Exxon stock in your 401(k). The cost basis of the Exxon stock is $50,000. You also have $100,000 in other mutual fund investments in the plan.

When you reach a “triggering event” such as retirement or reaching a certain age (like 59.5), you can make a special election when you distribute your 401(k). There are very specific rules for the sequence of events, so we recommend that you work closely with your advisor, your tax professional, and your HR department to make sure everything proceeds as needed.

Step 1: Make an in-kind, lump-sum distribution of the entire account within the calendar year. This means that you don’t sell the shares of the stock but rather transfer the shares to a taxable brokerage account.

Step 2: Roll the $100,000 of non-stock assets left in the plan to an IRA. Make sure the entire 401(k) is empty by the end of the calendar year.

You will pay ordinary income tax on the $50,000 basis in the Exxon stock (and possibly a 10% penalty depending on your age). However, now, if you sell the shares of stock in your new brokerage account, they will be subject to the capital gains tax rate, which is often significantly lower than your ordinary income tax rate. You can choose to sell the shares all at once or diversify slowly over time.

Helpfully, the tax code also allows you to pick and choose which shares to transfer to the brokerage account. For instance, you may choose to move the lowest basis shares to the brokerage account and roll the rest to an IRA.

There are both pros and cons to this strategy, and some of the advantages may change or disappear depending on future tax code changes.

The biggest downside is that you pay taxes on part of the distribution (the basis of the stock) that otherwise could have been deferred until your Required Minimum Distributions start at age 72. So, if there isn’t a significant gain on the stock, it may not make sense to deploy this strategy. And if the company stock pays a dividend, you’ll have to start paying taxes on that income once it hits the brokerage account. Finally, the NUA shares are not eligible to be “stepped up” at your death, unlike other appreciated securities. But for those holding employer stock (or qualifying stock fund) in a 401(k) or ESOP where the gains outweigh these losses, the NUA strategy can be a good option for avoiding some taxes in retirement.