The tax code contains a not-so-secret secret: the tax break for "net unrealized appreciation," which can help you save tax dollars when you have employer stock in your retirement plan. Here's how the break works.
Normally, you can accumulate assets in a qualified retirement plan at work, such as a 401(k) plan, without paying any current tax until you take withdrawals from the plan. At that point, distributions are taxed at ordinary income tax rates, which can be as high as 39.6%. The result: you could face a hefty tax bill when you retire and begin taking distributions.
However, if your account consists in total or in part of your employer's stock, and you take a lump-sum distribution in the form of stock instead of a cash payout, you can defer part of the federal income tax. In that situation, your cost basis in the stock is taxed at ordinary rates at the time of distribution (you may also owe a penalty). Tax on the difference between your basis in the stock and the value at the date of the distribution — the net unrealized appreciation — is deferred until you sell the stock.
Here's an example. Say you’re holding 20,000 shares of company stock in your 401(k). You bought the stock at an average price of $10 a share, so your basis is $200,000. Currently, the stock is valued at $50 a share, for a total of $1 million. You expect to be in the 39.6% bracket in retirement.
If you roll your retirement account into an IRA to defer tax and take distributions from the IRA when you retire, those distributions are taxable at your ordinary tax rate. But if you take an immediate lump-sum distribution from your retirement account in the form of company stock, in the current year you'll pay income tax on your cost basis of $200,000. The net unrealized appreciation is not taxed until you sell the stock. At that point, you'll use long-term capital gain rates to calculate the tax on the appreciation (including any additional appreciation from the date of the distribution). The potential saving is the difference between your ordinary tax rate and the generally lower capital gain rate. Be aware the 3.8% net investment income tax may apply.
To qualify for this tax break, the stock distribution must come from a qualified retirement plan, be due to death, attaining age 59½, or separation from service, and be made in a single tax year. Because the rules can be complex, we urge you to contact us for an explanation of your options.
