Company Stock In Your 401(K)? Don't Make My Costly Mistake

Summary

• Company stock in your 401(k) has special rules, specifically an available tax treatment called Net Unrealized Appreciation.
• Under the right circumstances, you pay only the capital gains tax rate on appreciation, rather than regular income rates.
• Proceed with caution any time you consider selling, rolling over, or withdrawing shares of company stock in your plan.

I recently took a critical look at my portfolio and decided I finally agreed with what advisors, formal and otherwise, had told me for years: I was much too concentrated in a single stock.

Fortunately for me, the concentration was in a good place. I worked for Microsoft (NASDAQ:MSFT) for a few years in the early 1990s. While there, I took advantage of three ways to invest in the company stock:

• An employee stock purchase plan, which allowed us to buy stock with a payroll deduction into a taxable account
• Options on the stock, offered as an incentive, and
• Employees could put their 401(k) money into company stock.

Between the three, I accumulated some stock in both my taxable account and in my 401(k). When I left the company, I kept the 401(k) plan intact, including the stock I kept within the plan.

Twenty years later, the value of those shares has grown substantially.

As you probably know, a 401(k) plan allows pre-tax money to be invested, which reduces your taxable income and helps you pay a lower tax bill the year it was earned. Those dollars, plus (usually) any investment gains, are taxed as regular income when you withdraw them in retirement. You get the advantage of delaying the tax (tax deferment), and also pay a lower overall tax if your marginal rate at retirement is lower than when the money was earned in the first place.

Because the money has never been taxed, when you make trades within a 401(k) plan, those trades do not create a taxable event, since you square up with the IRS upon withdrawal in retirement. You can often rebalance your whole portfolio by moving things around within your tax-advantaged plans like a 401(k), without triggering any capital-gains taxes. For instance, if you decide you need a higher concentration of bonds in your overall portfolio, and don't want to trigger capital-gains in your taxable account, you could shift assets in your 401(k) enough to put your overall portfolio balance where you want it.

Since I had too much single-stock risk in my overall portfolio, I decided I would sell the MSFT shares within the 401(k) and invest that money elsewhere within the plan, avoiding the capital gains tax I would have had to pay if I instead had sold the shares in my taxable account.

I sold the shares within the 401(k) and invested in another plan option, but that turned out to be a big mistake. While I did accomplish what I set out to do -- reduce concentration risk and avoid capital gains tax -- I missed out on a huge opportunity to further reduce my eventual taxes using a tax treatment called Net Unrealized Appreciation (NUA).

NUA isn't discussed as much as it should be. I only discovered the concept when reading the fine print of the plan at my current employer. In all of the thousands of articles on Seeking Alpha, I've seen it mentioned only twice:

1. Segment Wealth's Instablog has a great entry on this and gets into the motives as to why brokerages don't bring it up.
2. Chris Jaccard makes a brief mention of it in a recent article: Beware The Rollover Offer: 5 Important Questions To Ask

Companies that administer 401(k) plans ought to make the NUA implications a lot more obvious, any time an employee attempts to dispose of company stock in a retirement plan (I'm talking to you, Fidelity!).

Under the NUA treatment, if you withdraw your company shares from the 401(k) in-kind (that is, as shares rather than dollars) into a regular brokerage account, you pay regular income tax only on the amount up to your cost basis in the stock. When you eventually sell those shares outside of the plan, you only pay long-term capital gains on the appreciation.

To illustrate: Say you've paid $10,000 within your 401(k) for company stock that is now worth $50,000. If you treat it like any other 401(k) investment (like I did!) and sell it (or reinvest it somewhere else within the plan), you'll eventually pay regular income tax on the whole $50,000, since none of these dollars has been taxed. If your tax rate upon withdrawal is 28%, that's a $14,000 tax bill.

Instead, using NUA rules, if you had withdrawn the shares in-kind to a brokerage account, and immediately sold them, you would have paid 28% on your $10,000 cost basis, for $2,800 in taxes, plus the long-term capital gains tax on the appreciation. As of this writing, that rate is 15% for someone otherwise in a 28% bracket, so the tax on the $40,000 gain is just $6,000, for a total tax bill of $8,800.

So, in this example, the NUA treatment would save $5,200 in taxes. Even if the shares had been withdrawn pre-retirement and subject to the additional 10% tax penalty on the amount treated as income (the $10,000 cost basis), that would add only $1,000 to the total taxes and you'd still be ahead $4,200.

CalcXML.com has a nice online calculator for looking at the impact of NUA vs. an IRA rollover.

Additionally, there's no need to immediately sell the shares once they are in your taxable account, and no required minimum distributions. It's like any other regular taxable investment at that point.

With all that said, I don't recommend investing much 401(k) money into your own employer's stock, primarily because if something goes terribly wrong, you risk your job and your retirement. I will likely expand on this in a future article.

But if you do invest in your company stock in your 401(k), before you sell it, reinvest it, or roll it into another plan, do yourself a favor and check out your NUA options.

Disclosure: I am/we are long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.