Nobody likes taxes unless they are the lesser of two evils. So when you have an opportunity to snag a lower tax rate, take it. Here’s such an opportunity for some 401k accounts.
IRS Notice 98-24 Details Net Unrealized Appreciation Rules in Employer Securities.
Many workers own stock in their employer’s publicly-traded company (For example, you work for Chevron and you have Chevron stock in your 401k account). Often, this stock is rolled into an IRA when people retire because they think that this is their best option.
The IRS, however, gives you another, and often better option that could save you thousands of dollars when it’s time to retire and take your 401k withdrawal.
When you eventually withdraw money from an IRA, whether to meet your expenses or Required Minimum Distributions (RMD), it will be taxed as ordinary income.
DIVERSIFY & GROW YOUR IRA
WITH METALS & CRYPTOS
REQUEST YOUR FREE 2020 INVESTORS KIT
This is your highest tax rate. And you’ll have to pay the same tax rate on company stock that you had rolled over to the account. But there is a way to avoid the tax on the stock’s Net Unrealized Appreciation (NUA) that is if you did your 401k withdrawal correctly years earlier.
The NUA is the difference in the stock’s value from the time it was purchased in your 401k account to the time you withdrew it from the 401k plan.
If you withdraw the stock from the 401k, and NOT roll it over to an IRA as is often done, you will only pay ordinary income tax on the cost of the stock when it was acquired by the plan (hopefully, when the value was much lower years ago).
As soon as you consummate a 401k withdrawal of the stock to a regular brokerage account you would simultaneously rollover the balance of your plan’s assets to an IRA.
That way, the non-employer shares continue to grow tax-deferred. So the very good news is that even though you pay tax today on your 401k withdrawal of employer shares, the tax is only on the original cost of your employer’s shares AND you have locked in a favorable capital gains rate for later (assuming of course, that the government still offers a favorable capital gains rate in the future).
Years from now, when you get rid of the stock, you will only pay the lower, long-term capital gains rate on the NUA. And since the standard one-year holding period does not apply to NUA, you could sell the stock the day after consummate your 401(k) withdrawal and pay the lesser capital gains rate. However, to receive the capital gains rate on future appreciation, you must own the stock for more than one year. If not, you will have to pay the ordinary income tax rate.
Your loved ones also like this option.
When beneficiaries inherit IRAs, they must pay ordinary income taxes on all of those funds. Inherited NUA stock, however, gets a better deal. Heirs can take advantage of the same favorable treatment as you all because at the one moment in time, you correctly opted to make a 401k withdrawal of the shares. The heirs will receive the stock at your cost basis and pay tax on the NUA at the capital gains rate. Plus they get a special break if you had used the NUA rule: appreciation from the date you removed the stock from the plan to the date you died will receive a step-up in basis and pass income-tax-free, under current rules.
So before you rollover your 401k into an IRA, as most people blindly do, check to see if you have shares of your employer’s stock as an IRA asset. If so, taking those shares as a 401k withdrawal and benefiting by an IRA tax break could save you a lot of cash.