The Dangers of Rolling Your Company Stock into an IRA


The Dow Jones Indus­trial Average is approaching its all-time high of 14,000. Eventually it will reach a new high, rewarding those investors that were patient and especially those that continued to invest during the downturn. Investors that added money to their company 401(k) and in particular bought their company stock while it was low have an added tax advantage that they need to keep in mind when retiring.The best way to explain this technique is to tell you the story of Rodney Hartwell, whose stock distri­b­u­tions from his tax-deferred retirement plan weren’t struc­tured in the most tax-efficient way possible:

Case Study: Rodney Hartwell, medical supply executive

Rodney Hartwell, an executive at a medical supply company, was planning on retiring at year-end. Rodney had $100,000 worth of employer’s stock held in the company’s 401(k) plan with a cost basis of $20,000. A local investment advisor recom­mended Rodney roll his company stock into a low-cost IRA, explaining the advan­tages of the IRA and telling Rodney his account would grow larger because the tax would be deferred—and there was also the likelihood of potential returns with the hot mutual fund he just happened to be recom­mending for the IRA.

The advice this investment advisor gave to Rodney wasn’t unusual, since tax-deferred savings accounts are most people’s go-to method of saving for retirement. But as I mentioned in my book “The New Three Legged Stool”, the major problem with this scenario is every dollar a retiree wants to spend is going to be taxable when he or she reaches for it.

The advisor likely failed to explain the downside of this unfor­tunate fact to Rodney, and so when his IRA eventually began to distribute income, that income was taxed at ordinary income rates on his $20,000 cost basis and could eventually have been taxed even higher (35%) on his $80,000 gain.

The advisor should have recom­mended Rodney use an often-overlooked tax strategy known as net unrealized appre­ci­ation (NUA). How does an NUA work? Here’s an example. An employee is about to retire and qualifies for a lump sum distri­b­ution from a qualified retirement plan. He elects to use the NUA strategy, receives the stock, and pays ordinary income tax on the average cost basis, which repre­sents the original cost of the shares. This strategy allows the tax to be deferred on any appre­ci­ation that accrues from the time the stock is distributed until it’s finally sold.

Note the NUA distri­b­ution must be taken as a lump sum distri­b­ution, not a partial lump sum distri­b­ution, and in order to qualify for a lump sum distri­b­ution, the employee must take the distri­b­ution all within the same calendar year.

The NUA strategy would have allowed Rodney to receive an in-kind distri­b­ution of his company’s stock and pay income tax only on the average cost basis of the shares, rather than on the current market value. In that case, Hartwell’s tax on the $80,000 gain would be treated as long-term capital gains and taxed at a maximum of 15%, resulting in a potential tax savings of $12,000. (Of course, the $20,000 basis would be taxed as ordinary income.)

Five Steps to a Successful NUA Trans­action

Before exercising a distri­b­ution or rollover, follow these five steps designed to help you under­stand what it takes to complete a successful NUA trans­action.

  1. Start early—the NUA trans­action may take several weeks. Make sure you obtain a written copy of your cost basis before initi­ating the rollover. You can get formal documen­tation of the cost basis of the company stock; you can also request formal documen­tation showing your employer’s promise to make an in-kind distri­b­ution of the company shares.
  2. Determine the amount of gain in the stock price. In an employer- sponsored retirement plan, you can elect an NUA on some, all, or none of the shares. Note, however, on shares you bought for more than the current stock price, it’s not logical to elect this strategy. Instead, seek out shares that are currently selling for twice your cost basis.
  3. Select the sequence of trans­ac­tions when the plan holds other assets in addition to employer securities. You can transfer the company stock portion (which still qualifies for the tax break on the NUA) to a taxable (non-IRA) brokerage account, and you can roll the non-company stock portion of the plan into an IRA rollover account. You should execute the IRA rollover first for all assets except the company stock, then the NUA shares can be distributed in-kind, with nothing to withhold for the IRS from either trans­action. Note that unless it’s a trustee-to-trustee transfer, or the only remaining asset being distributed is employer stock, your employer should withhold 20% of distri­b­u­tions from a qualified plan for taxes.
  4. Know Your Liabil­ities. You should have your tax profes­sional prepare a tax projection to determine the amount needed, and be prepared to pay the tax man in April.
  5. Prepare an exit strategy. Assuming you’re optimistic about your company’s future and proceed with the in-kind distri­b­ution, you should still have an exit strategy if the stock starts to decline. One possi­bility would be to give some or all of the stock to a chari­table remainder unitrust (CRUT). Once the stock is trans­ferred to a CRUT, the shares can be sold by the trustee and reinvested in a diver­sified portfolio that can provide lifelong income to the donor. The chari­table deduction might even offset most of the tax oblig­ation on the cost basis.

A few words of caution before you jump on the NUA bandwagon: first, an NUA distri­b­ution may not be a good idea if the company’s outlook is bleak. The tax benefits are wasted if the company stock declines signif­i­cantly after the distri­b­ution. An investor with 98% of his retirement account tied up in one stock may want to consider liqui­dating a portion of his stock position and distrib­uting a smaller portion of the stock in-kind. Second, never ask for in-kind distri­b­u­tions of company stock in December. It’s better to wait until the beginning of the next year because the entire distri­b­ution (rollover and in-kind distri­b­ution) must be completed in the same calendar year.

Rick’s Insights

  • If you own large quantities of company stock inside a retirement plan, you should know about Net Unrealized Appre­ci­ation (NUA).
  • NUA allows the tax to be deferred on any appre­ci­ation that accrues from the time the stock is distributed until it’s finally sold.