STOP: Look Before Rolling Company Stock into an IRA

Edition: February 2002 - Vol 10 Number 02
Article#: 1157
Author: Richard Yercheck

It's common for employees with company stock in their retirement plans to roll that stock over into an individual retirement account (IRA) when they change employers or retire. That can be a costly mistake, caution an increasing number of retirement experts.

What workers may be overlooking is a little-known company stock benefit called net unrealized appreciation. Here's how it works, and how it can save you money if company stock makes up a chunk of your retirement plan at work.

Say you own $400,000 in company stock in your 401(k) plan and you prepare to retire at age 65. The average cost basis for each share is $20 and the stock is currently worth $70 a share. Typically, you would roll over the stock, along with any cash or other investments inside the account, into an IRA and let it continue to grow tax deferred. However, when you begin withdrawing funds, they will be subject to ordinary income taxes. You will have lost any chance of paying lower long-term capital gains rates on the stock.

The other downside is that when you die, your heirs won't receive the company stock with a step-up in basis – that is, they'll pay ordinary income taxes on the value of the stock at the time the IRA owner dies.

An alternative is to roll over the cash and the other investments into an IRA, but have the stock distributed directly to you. This must be done before any post-retirement distributions are made, and it must be part of a single lump sum distribution. It can't be part of a partial distribution.

Yikes! You may protest – that means it's going to be taxed immediately. Yes, it will, but not as much as you think. And the long-term tax benefits could be substantial.

You will be taxed at your ordinary income tax rates on the cost basis of the stock - $20 in this example. If you hold on to the stock for a while, that's the only immediate tax you'll pay, with the exception of a ten percent early withdrawal penalty if you are younger than age 59_. But that, too, is paid only on the cost basis of the stock. On the other hand, you may want to sell some or all of the stock immediately, perhaps to diversify your portfolio so it's not so heavily steeped in a single stock or because the stock's future prospects aren't good.

Whenever you sell it, you'll pay long-term capital gains rate – 20 percent maximum – on what is called the net unrealized appreciation (NUA). That's the difference between the cost basis and the value of the stock when you receive the distribution. In this example, that's $50 ($70 - $20). The long-term capital gains rate applies on the NUA regardless of the holding period following distribution. Say you hold on to the stock for a while before selling it at $90 a share. That additional $20 gain will be subject to capital gains tax – at your ordinary income tax rate if you sell the stock within a year of distribution, or long-term cap gains rate if held longer than a year.

When it comes to the estate planning implications of this strategy, things get a bit more complicated, and sometimes they've been misreported in the press. It's not true that if you hold the stock until death that the heirs will receive it on a step-up basis. There is no step-up in basis on the NUA portion – the $50 gain in our example. However, any appreciation above the NUA portion - $20 in our example – does receive a step-up in basis at death.

Before committing to this little-known net unrealized appreciation strategy, run it by your tax professional. The decision to do it or roll it into an IRA or other strategy will depend on several factors, such as the amount of the NUA, whether other investment alternatives are more likely to appreciate better than the company stock, whether you want to sell quickly to pay for retirement or whether you want to bequeath the shares to your heirs. Also check with your benefits department at work well in advance. Some plans don't allow separate distribution of company stock, and some departments are not familiar with the NUA strategy.

How to Diversify Employer's Stock
Bill Gates did it. So did Michael Dell and the Walton clan and many of the wealthiest people in America. Why shouldn't you?

They all got rich by betting on a single stock. That's what a lot of today's employees are hoping to do, too, by investing heavily in their employer's stock through stock options, discounted purchases of stock, and employer funding of pension plans or matching employee retirement plan contributions with company stock.

However, many financial advisors caution that although loading up on company stock can make you very wealthy, it also can increase your risk. Your portfolio, as well as your job, is riding on the fortunes of a single company. That company may look very good at the moment, but that's not a future guarantee. Consider the fate for employees heavily invested in the following companies.

After hitting a high within the last year of $120 a share, Microsoft was down to $67 a share in mid-September
• fell from 113 to 45
•        Puma Technology dropped from 102 to 24
•        AOL went from 96 to 56

It isn't just tech stocks, either. Consider the employees of “old economy” stalwart Procter & Gamble, whose company stock makes up 93% of their profit-sharing retirement plan. That was great when the stock was returning years of double digit returns, often well above S&P 500 returns. But then it started falling well behind the S&P, and in 2000, P&G stock fell from a January high of 118 a share to a low of 53, before rebounding slightly by mid-September to 61.

Most of these stocks will rebound fully in time, and then some. Furthermore, there are tax advantages to holding company stock until retirement and putting it into a taxable account instead of rolling it over into an individual retirement account. There also may be tax advantages if you plan to pass stocks on to your heirs. In the meantime, however, it makes for tremendous volatility for employee or retiree investors. If company stock is the principal source for retirement income, steep price declines can delay or derail plans to retire, or reduce retirement lifestyle.

A well-diversified portfolio minimizes the impact of a dramatic decline in one or two or even several stocks. Indeed, most investors building an investment portfolio from scratch would never commit 93 percent of their assets to a single stock – they know that's poor diversification. Yet employees – particularly executives at start-up companies but even rank-and-file at seasoned companies – routinely load up their portfolio with employer stock.

Many Financial Professionals prefer to see their clients keep a much lower company stock commitment. How much lower varies from planner to planner, but might range from as little as 5 percent to as high as 35 percent.

Diversifying often isn't easy for employees, since companies often will match retirement contributions only with company stock, they pressure employees to invest in the company, or they may restrict the sale of company stock. Here are several strategies for diversifying.

Keep the rest of your portfolio in different industries or types of assets. If your employer stock is large cap, consider putting the rest of your money in such assets as small cap, international bonds.

Buying employer stock sold at a discount is probably too good to deal to pass up, but try selling older shares at the same time so you don't increase your overall position.

Don't dump the stock all at once, even if you can. Spread out selling to reduce volatility and minimize the tax bite.

Consider more sophisticated strategies such as “collars,” which can effectively lock in a price, or tax-free swaps of stock through an exchange fund.

Work closely with a financial advisor and tax advisor when determining how much company stock you should have in your portfolio, and when choosing diversification strategies. Stock options, for example, have complex tax as well as investment issues, and the timing of sales is critical.

Richard Yercheck
is a Financial Consultant with IJL Wachovia in Charlotte, NC. For more information, please call Richard at 800-929-0724. IJL Wachovia is a division of Wachovia Securities, Inc., Member NYSE and SIPC, and a separate non-bank affiliate of Wachovia Corporation.