By: Richard Feldman
By: Richard Feldman, CFP, MBA, AIF
Understanding the tax consequences of holding employer stock in a retirement plan can yield huge tax savings at retirement. Holding employer stock inside a qualified retirement plan has become a hot topic recently because of the accounting scandals at WorldCom and Enron and the market downturn of 2000-2002. Think Lucent, JDSU, Cisco, Intel, Corning and thousands of other companies. Many Americans lost a large percentage of their net worth by holding a large block of employer stock inside their retirement plan and watching that employer stock lose 50 – 80% of its value or 100% in the case of Enron and WorldCom. The last few years has cast increasing scrutiny over the practice of allowing employer stock in retirement plans and has overshadowed what has been traditionally a great way to participate in the growth of the company you work at. Think GE, P&G, Home Depot, Lowes, Coke, and Microsoft. This article will not address the risk of holding employer stock inside a retirement plan rather it will address an interesting aspect of the current debate which is the potential tax benefit associated with holding employer stock particularly by those who are highly compensated employees and may have substantial investments in employer stock in their retirement accounts.
Net Unrealized Appreciation
This term refers to the appreciation in the value of employer securities (Stock) held in a qualified retirement plan from the time the stock was originally placed in the participant’s qualified plan account to the time of distribution of the stock. The central issue in dealing with NUA is the special tax advantages afforded employer stock that is subject to NUA. The internal Revenue Code favorably treats NUA in certain situations, deferring taxation of the appreciation until the employer stock is actually sold [Sec. 402 (e) (4), I.R.C.].
Suppose, for example, that Jim Smith has accumulated employer stock in his retirement account. The shares in the plan were valued at $100,000 when acquired by the plan meaning that they have a tax basis of $100,000. The shares have grown in value to a million dollars. If Jim retires and withdraws those shares he’ll owe taxes on the basis of those shares ($100,000) at ordinary income tax rates. In this example the Net Unrealized Appreciation (NUA) is $900,000. If Jim subsequently sells the shares outside of the retirement plan he will be taxed at the new 15% long-term capital gains rate.
Another approach which most individuals are familiar with is a rollover of the retirement plan to an Individual Retirement Account (IRA). This approach would involve selling all the securities in the retirement plan and rollover the proceeds to an IRA. This method allows the individual to defer the taxation on the retirement funds since no income taxes will be due and payable until such time as distributions are made from the IRA. Distributions that are taken from IRAs are taxed at ordinary income tax rates, which can be as high as 35%.
The ultimate benefit to a high tax bracket individual is having the proceeds qualify for long-term capital gain rates rather than ordinary income taxes. If you keep all the shares in the plan and roll them over to an IRA all the appreciation of the employer stock will be turned into ordinary income upon withdrawal which could have a tax rate a full 20% higher than long-term capital gains rates.
If you continue to hold the stock once it was rolled out of the retirement plan the dividends on the employer stock will be taxed at the new 15% dividend rates rather than ordinary income tax rates if the dividends were paid inside an IRA.
Employer stock that has been distributed from an employer plan will receive a step up in basis at death for the individual’s beneficiaries and heirs. This provides a significant income tax benefit to the beneficiaries who will escape significant income taxation on a portion of the estate that is eligible for NUA.
A significant portion of an individuals total net worth could theoretically be tied up in one stock. This greatly increases the total risk of a portfolio and every effort should be made to reduce this company specific risk. There are many options that an individual has to reduce this company specific risk.
Sell the whole block: An individual can sell the whole block of stock and take the proceeds and buy a diversified portfolio of equities, bonds, and Reits. With the passing of the new tax law an individual would have 85% of the NUA to invest rather than 80% because of the reduction of long-term capital gains rates from 20% to 15%.
Gifting: Individuals may gift up to $11,000 worth of cash and securities each year and avoid gift taxes. If an individual is married and has a child who might be attending college he could gift the child $22,000 of the securities per year to help pay for college. If the child were in the lowest tax bracket, the capital gains rate on the eventual sale of the stock would only be 5%.
Charitable Remainder Trust: Another strategy would be to gift the shares to a CRT. The CRT can sell the shares without owing any tax because it is a charitable trust. A diversified portfolio could then be designed to provide an income stream to the individual.
Exchange Fund: These funds are private partnerships formed by Wall Street firms. Each individual partner contributes appreciated stock to the partnership assets, which become diversified based on the equity contributions of the partners. After a few years, exchange funds terminate according to the partnership agreement. They generally distribute their assets to each partner pro rata meaning that the individual will end up with a portion of each stock that was contributed to the partnership.
Options and Collars: Wall Street firms have designed techniques to limit the downside on concentrated equity positions if an individual is willing to limit their upside potential.
The existence of substantial NUA in an individuals retirement plan provides significant tax planning opportunities. An analysis of the individuals circumstance would have to be undertaken in order to conclude whether they would be better served by taking a distribution of NUA stock and paying ordinary income on the cost basis of those shares or deferring taxation by selling the shares and rolling over the proceeds to an IRA. The NUA tax break was valuable under the prior tax code but now has become even better. The new tax law has decreased tax rates on each marginal bracket by 2-3 percentage points. Individuals will benefit because their IRA distributions will now be taxed at a lower rate. The capital gains rate, however, has decreased by a full 5% points. This has substantially increased the advantage of paying capital gains on NUA stock versus ordinary income tax rates on IRA withdrawals. The problem with this technique is that not many people are aware of this option until after the transaction has already been completed.
If you are contemplating this technique, please contact your tax advisor in order to do a thorough analysis of the entire transaction including alternative minimum tax consequences. In addition, you should also consult a financial advisor to explore which technique is most appropriate to reduce the concentration issues associated with holding employer stock.