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Minimizing taxes on employer stock in your 401(k) plan

Cash Flow and Retirement

If you’re approaching retirement and your 401(k) plan contains significant holdings in appreciated employer stock, you may be able to minimize taxes on that stock. The strategy, which takes advantage of the net unrealized appreciation (NUA) rules, isn’t right for everyone in this situation. But it’s worth exploring before you start withdrawing funds from your 401(k) plan or rolling them over into an IRA.

3 steps

Typically, distributions from 401(k) plans or traditional IRAs are taxable as ordinary income. But under the NUA rules, you can elect to defer taxes on the appreciation in value of employer stock until the shares are liquidated. At that time, appreciation may be taxable at favorable long-term capital gain rates.

The rules are complicated, but in general, you should:

  1. Take a lump sum distribution of your entire 401(k) account at a time when you’re eligible due to separation from your employer, disability or reaching age 59½. You must receive actual shares of employer stock rather than their cash value.
  2. Move some or all of those shares to a taxable brokerage account, paying ordinary income tax on the stock’s cost basis when the stock is distributed to you. Tax on the shares’ net unrealized appreciation is deferred until you sell them.
  3. Roll over any other 401(k) assets into an IRA.

If executed carefully, this process can reduce taxes on the sale of employer stock. But for that to happen, the stock should be distributed at a time when you have little or no taxable income — for example, when you’ve first retired but haven’t yet begun to receive Social Security benefits, pensions and other income. Ideally, you would want to time the liquidation of your employer stock shares so that it makes the most of the 0% capital gains tax rate for lower tax brackets.

But before you execute this strategy, think about the broader impact of moving funds into a taxable account — and the possible alternatives. You might, for example, benefit from options such as leaving the funds in your existing plan or transferring them into a new employer’s plan. Also consider fees, expenses, investment options and creditor protections.

Other ways to reduce risk

Holding a substantial amount of wealth in one company’s stock is risky. Also, changes in the tax law could reduce or eliminate benefits associated with the NUA strategy. Your tax or legal advisor can help you determine whether it makes sense given your situation, or whether there are other ways to reduce tax liability.

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