If you have employer stock in your retirement plan (typically in a 401k or an employee stock ownership plan), rolling over that stock to an IRA when you leave that employer may be a mistake. As always, it depends on your individual circumstances, but think twice before you make this decision. Here’s the skinny.
A withdrawal of employer stock from an employer retirement plan is eligible for special tax treatment. (Note this only applies to your employer’s stock, not to the stocks of other companies you may invest in.) Called “net unrealized appreciation,” or NUA, a withdrawal of company stock–rather than say selling that company stock and withdrawing cash–is taxed as ordinary income on the cost basis of the stock at the time of distribution. Note it’s the cost basis of the stock, not the current market value, that is the key point for this tax strategy. A simple example may help.
Sally’s employer contributed 100 shares of employer stock to her 401k account several years ago. Each share was worth $10 at the time (so a total contribution of $1,000, her cost basis). Now at age 63, Sally retires and wants to roll her 401k account to an IRA; her 401k has mutual funds as well as the 100 shares of employer stock, now worth $50 per share. On the advice of her financial planner, Sally rolls only the mutual funds to an IRA. However, she withdraws the employer stock as actual stock, rather than converting it to cash or rolling the stock to an IRA. Sally now has $5,000 of company stock in her possession, but she will only pay income tax on the $1,000 cost basis. What happens to the other $4,000 (the net unrealized appreciation)??
Nothing, until Sally decides to sell that stock. When she does, here’s the big tax benefit: all her gain ($4,000 at this point, but it could be even more if the stock goes up in value in the future) will be taxed as capital gains. Capital gain tax rates are much lower than ordinary income tax rates (currently–of course, this could change in the future!).
If Sally had instead rolled her employer stock to an IRA and eventually sold it inside the IRA, when she withdraws that cash it will be taxed at the higher ordinary income tax rates; all money withdrawn from an IRA is taxed as ordinary income (we’re talking traditional IRAs and rollover IRAs here, not Roth IRAs).
By taking her withdrawal in company stock when she left her employer, Sally essentially converted what would have been ordinary income into capital gains income. And capital gains income gets much better tax treatment (today). And that’s the big benefit of using the net unrealized appreciation tax strategy for employer stock in a retirement plan. It’s just one more technique to save potentially hundreds or thousands of tax dollars to help maximize your retirement readiness.