Lessen tax bite when rolling over 401(k) assets

PERSONAL FINANCE

September 24, 2006|By EILEEN AMBROSE

For many workers leaving a job, the wise financial move is to roll their 401(k) into an IRA.

But if you're holding highly appreciated shares of employer stock, there's another strategy worth checking out. Though complicated, it could save you thousands of dollars in taxes if done right.

"Many people are not aware of this tax benefit," said Ed Slott, an IRA expert in Rockville Centre, N.Y. "It's one of those things if you don't ask for it, it's highly unlikely someone will tip you off to it."

The strategy is called "net unrealized appreciation," or NUA. It's not new, but may attract more interest now with millions of baby boomers poised for retirement and thousands of long-term workers weighing buyout offers, Slott said.

You can take advantage of net unrealized appreciation when getting a lump sum distribution from a 401(k) when you retire or leave the job for some other reason.

Rolling 401(k) assets into an individual retirement account won't trigger an immediate tax hit. But when you take money out of the IRA, it will be taxed as regular income -- at a rate of up to 35 percent.

The net unrealized appreciation strategy lessens the tax bite. It allows you to transfer all or some of you employer stock from the 401(k) into a taxable brokerage account. (The balance of the 401(k) is still rolled into an IRA.)

You will owe regular income tax upfront on the amount you paid for the shares, which is called the cost basis. But all the appreciation in the shares will be taxed at the capital gains tax rate -- typically 15 percent -- whenever you sell the shares. This can be a sizable savings.

For example:

A retiring 62-year-old paid $25,000 over the years for company stock that is now worth $125,000. She is in the 25 percent tax bracket.

By transferring those shares out of the 401(k), she will owe regular income tax -- or $6,250 -- on the cost basis upfront. Say she immediately sells the shares. She will be taxed on the $100,000 gain at a rate of 15 percent. Her total tax bill: $21,250.

In comparison, if the shares had first been rolled into an IRA and then withdrawn, her tax bill would be $31,250. That's $10,000 more.

Of course, there's a danger of owning too much employer stock: the lesson from Enron's collapse.

Christine Fahlund, senior financial planner at T. Rowe Price Associates, suggests workers try to limit company stock to 5 percent of their entire portfolio.

The new pension law makes it easier for workers to avoid larding up a 401(k) with employer stock. Beginning next year, employers that match workers' contributions with company stock will generally have to allow employees to sell the shares after three years of service, Fahlund said. And workers must get at least three other investment options.

Even before the law, though, some employers were discouraging workers from going overboard on company stock, benefits experts said.

"Everyone got gun-shy after Enron, and for good reason," Fahlund said.

Still, many workers out of loyalty, comfort or inertia continue to own a great deal of employer stock, concluded a Hewitt Associates' survey last year of 1.7 million 401(k) participants.

One out of five workers invested half or more of their 401(k) money in company stock, Hewitt found. These tended to be workers with 30 or more years with the company.

David Foster, an accountant and financial planner in Cincinnati, says many of his clients come in loaded up with company stock from Procter & Gamble's retirement plan.

"It's not uncommon to see a 55-year-old with 95 percent of his money, or even 100 percent, in P&G stock," Foster said. "I happen to be in the hotbed of NUA."

Still, this tax maneuver isn't for everyone.

For instance, it's not worthwhile unless you have greatly appreciated company stock in a 401(k). (The strategy also applies to qualified employee stock ownership plans, Slott said.)

Age is another consideration. If you leave the company before age 55, you will owe a 10 percent early withdrawal penalty on the cost basis of the stock. That can be thousands of dollars and too steep a penalty for some, Foster said.

And there's the issue of diversification. By holding a large amount of a single stock, your portfolio could plummet if the former employer runs into bad times.

If you decide this strategy may be for you, consult with a professional who has expertise in this area. There are so many chances to make mistakes that can't be undone.

"There are a lot of very specific rules you have to comply with to do this properly," said Michael Kitces, a financial planner in Columbia. "If you do any of them wrong ... you have some unpleasant tax consequences."

To be eligible for this strategy requires taking a lump sum distribution after a certain event, such as a disability, leaving the company or reaching age 59 1/2 . Workers must empty the entire 401(k) account in a single calendar year, or lose the tax break, Slott said.

One common mistake is rolling the 401(k) account into an IRA and then trying to take advantage of net unrealized appreciation, experts said.

"Once you roll over your account to an IRA, the opportunity is permanently lost," Kitces said.

To compare taxes using this strategy or rolling money into an IRA, use the net unrealized appreciation calculator at www.finance.cch.com.

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@baltsun.com. Podcasts featuring Ambrose can be found at baltimoresun.com/ambrose

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