Employer Stock in Qualified Plan Creates Tax Benefits 10/21/07
Stewart H. Welch III, CFP, AEP
Founder, The Welch Group, LLC
Employer Stock in Qualified Plan Creates Tax Benefits
“Employer Stock in Qualified Plan Creates Tax Benefits”
Literally tens of millions of employees own stock in their company retirement plan. This is because they either have company stock as one of their investment options or their company provides ‘matching’ contributions using company stock. Most of these employees are unaware of a little-known tax strategy that could save them thousands of dollars in taxes at retirement.
Not only does an investment in your employer’s stock show your loyalty and faith in your company, but it can create potential tax benefits for you as well. Normally when people retire, they will “roll over” their company retirement plan money into an IRA and, at some point, begin taking distributions to provide for their retirement income needs. Under this scenario, all distributions are treated as ordinary income for income tax purposes. But what if you could use the more favorable capital gains tax rate for a portion of your retirement plan distributions? In fact, our tax code provides a little known option that allows you to do just that. Here’s how it works. When you leave your employer, you take a distribution of your company’s stock from your retirement plan and roll over the balance of your retirement account into an IRA or other employer’s retirement plan. You will pay ordinary income taxes on the “cost basis” of your employer’s stock, but the appreciation portion will be taxed at the more favorable capital gains tax rates. And these capital gains taxes are not due until you sell the stock. Sound complicated? Let’s look at an example.
Let’s assume that you are a Vulcan Materials employee who is about to retire after 20 years with the company. During your employment, you purchased 1,000 shares of Vulcan Materials stock through your 401(k) plan at an average cost of $10 per share. The stock is now worth $90 per share. At retirement you take the Vulcan Materials stock out of the plan and move it to a personal investment account. With the balance of your retirement plan you do an IRA rollover. As a result, you will immediately owe ordinary income taxes on $10,000, which is what you paid for the Vulcan stock (your cost basis). The remaining $80,000 would receive the more favorable long-term capital gains tax treatment (currently 15% maximum for federal). As an added bonus, you would not owe the taxes on this portion until you actually sell the stock! If the stock continues to appreciate, and you hold it until you die, you are allowed “stepped up cost basis” treatment on the additional appreciation at death. This means that if Vulcan Materials stock appreciated from $90 per share to $120 per share at your death, your heirs would owe no income taxes on the additional $30,000 of appreciation! Contrast this to having held the stock in your IRA rollover account. In that case, the entire account value would eventually be subject to ordinary income taxes (current maximum federal rate of 35%).
While our example focuses on 401(k) plans, this tax option also applies to Employee Stock Ownership Plans and other qualified plans. This is a technical area of tax law, but one where potentially big tax savings are at stake. For a nifty calculator showing you the actual advantage of this strategy go to the Resource Center at www.welchgroup.com and click on ‘Net Unrealized Appreciation Calculator’. Be sure to seek the advice of competent tax counsel.