Gil’s Musings

Tax Rule Creating Lasting Value for IRA Stocks

IRAs are a great tool for investors to defer taxes and continue to grow the full, pretax value of a retirement account. You may already know you can roll over your 401k into an IRA to maintain the tax deferral. But there’s a lesser-known advantage for investors who hold their company’s stock in a 401k. Provided you take the proper steps before you convert your 401k to an IRA, you can receive special tax handling for your stock.

This strategy is called a Net Unrealized Appreciation (NUA) Election. Prior to rolling a 401k into an IRA, a proper plan would simply look at the shares purchased at the lowest price range. You would distribute the combination of the amount of shares you wish to keep to your regular brokerage account, choosing those shares bought at the cheapest prices. This NUA would be a current taxable event, but only on the original investment amount. The profit would be carried over as a long-term unrealized gain, and would receive that treatment going forward.

This does not work well if you don’t want to hold shares going forward, if your position is small or you have a loss. This also is only for shares that you own in your employer’s company. It does not apply to options or company stock purchase plans, nor to any mutual funds you own in the plan.

Chances are, you never heard of the NUA Election. After many years in the brokerage business, I know first-hand that firms generally don’t like to talk about this strategy. While it offers significant tax advantages for investors, it also can cut the future management fees that brokerages collect from their clients. Brokerages prefer the traditional, tax-sheltered IRA rollover, including your company shares. Why? Because they can recommend their lucrative managed accounts or load mutual funds with no tax impact upon selling your shares. Unfortunately, under certain circumstances, this can be double jeopardy for the investor. Deferring the tax on selling the shares in a rollover does help, but that treatment is also available in a joint account by simply choosing to not sell shares. The value of deferring tax on those shares by selling in the IRA is unlikely to match the possibility of a much lower tax rate from capital gains on these shares, or even a tax-free step up if held until the death of any co-owner.

Another reason advisers don’t like company shares is they have to work around those shares in their allocation. This is cumbersome, and it’s tough to charge fees for such work on a brokerage platform. Most advisers also believe there’s something alchemistic about their allocation charts. Surely, it’s possible that your shares are likely to be just as profitable in the future as the same assets in their allocation. And I could argue that the combination of lower fees and taxes in those shares tips the scales to the share’s logical advantage. Remember, this strategy only works with shares that are already substantially profitable. You would only want to do this if you felt that trend would continue.

The strategy is not without risk, of course. You should consider what being wrong would mean to your retirement. Imagine Enron for a moment, in which employees who loaded up their 401ks with company stock lost everything. So exercise the proper caution, but also remember that while diversification is an important thing, it is not the only thing.

Recall as well that capital gains taxes are capped at just under 24%. This is not the case with the same shares held in an IRA. The shares in an IRA don’t receive a step up at death either, and the increased value over the years is always taxed at ordinary income tax rates, which can be more than 43%. This is especially important for older retirees or those whose spouses may be ailing. When considering your family’s future, imagine the power of leaving the kids or a surviving spouse these gains without the big tax burden. That isn’t going to happen if those shares are in an IRA.

So, if you find yourself retiring or leaving a company with a strong stock performance, you might want to ask yourself a few questions:

– Do you own company shares in the 401k plan that have appreciated greatly?

– Do you hold a reasonably large number of company shares?

– Do the shares have a large embedded gain?

If the answer to all of these questions is “yes,” – and remember, this special treatment must be elected prior to the rollover – then the NUA Election strategy could be just the ticket for you.

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