Many individuals working for a publicly-traded company tend to accumulate their employer’s stock in their 401(k). This can be a result of an employer’s policy of matching contributions with company stock, some other type of profit sharing incentive, or perhaps just the perception that one’s own company is less risky than a diversified portfolio of unfamiliar companies. While individuals holding their company’s stock in their 401(k) should consider the benefits of having a diversified portfolio (remember Enron); they should also keep in mind that these assets should be given special consideration when it is time to roll the 401(k) over to an IRA.
When a 401(k) is rolled over, typically the assets are liquidated and/or transferred into an IRA, which will postpone the tax liability until you take distributions. You can do this with the company stock, but when you take distributions, you will pay regular income tax on the fully-appreciated amount. An alternative strategy would be to roll the company stock into a taxable account and take advantage of a fairly obscure tax break on the Net Unrealized Appreciation (NUA).
Rather than roll the company stock into an IRA, transfer it into a taxable account. The tax will only be applied to the cost (or basis) of the stock when you purchased or received it. So, if you have company stock valued at $100,000, but the value when the stock was purchased or issued was only $30,000, you will only owe immediate taxes on the cost basis of $30,000. In addition, if you’re under age 55, you will likely pay a 10% penalty for early withdrawal.
After the stock has been transferred to a taxable account and held for a year, the liquidation of the stock is taxed at the long-term capital gains rate, rather than at regular income tax rates. Compare that to the tax implications of rolling the company stock directly into an IRA; once liquidated and distributed, you would pay regular income tax on the fully-appreciate value.
This strategy will not work if you sell your stock before rolling it to another account. It can also be applied when considering estate tax issues, as a NUA outlives the owner when assets are passed on to beneficiaries.