Drill Down: Company Stock in Your 401k
I pledged to keep this book simple, but I’m afraid I’m going to fail in this section. If, however, you are willing to work through this section, you may be able to save a good deal of taxes (enough even to make this section worth reading). You will find this material relevant if you have company stock in your 401k that has risen in value substantially.
Example: Jane’s company matches her 401k contribution by putting company stock into her account. The value of the stock, as of the day that each company contribution was made, totals $20,000. But the stock price has been going up, resulting in a total market value for the stock of $100,000.
Jane has an option not listed above, but she has to be careful to do it right:
- Set up a stock brokerage account and have the company stock transferred to that account.
- Have the rest of the money in the 401k rolled over into an IRA.
Both of these actions have to be taken in the same tax year. Note that Jane has to take out the actual company stock; she cannot sell the stock inside the 401k and then take out the money she receives from selling the stock.
Here’s what happens tax-wise to Jane. She is taxed this year on the cost basis of the stock. That’s the $20,000 that the stock was worth on the days she received her various matching contributions. She has to pay tax on that amount in the year that she moves her stock into her brokerage account. If she’s not yet 59½, she’ll also have to pay the ten percent penalty tax.
Now that sounds bad, paying a tax early, but the rest of the story is very nice. The profits on the stock will be taxed at the long-term capital gains tax rate, at the time that she eventually sells the stock.
Remember the normal taxation of 401k money: it’s all at regular tax rates.
As I am writing this, capital gains tax rates are much lower than regular tax rates (though who knows what those crazy guys in Congress will do next year). For instance, let’s assume that your income is in the range of $61,300 to $123,700. Your regular tax rate is 25 percent on any additional income. But long-term capital gains are only taxed at 15 percent.
Let’s do Jane’s arithmetic. The regular tax liability on the entire $100,000 (ignoring that the income would probably push her into a higher tax bracket) is $25,000.
By taking the stock out, she has a tax of 25 percent of $20,000 (which is $5,000) plus 15 percent of $80,000 (which is $12,000), for a total tax of $17,000. That’s a lot less than $25,000 if she has to pay regular income tax on top. Her state income tax, if any, would throw another complication into the Jane’s arithmetic.
However, this calculation is a little too simplistic. First, if all the stock goes into her IRA, she does not have to pay any tax at all until the money comes out. If she has other resources, she can delay taking any money at all out until she reaches 70½ years old, and even then she can withdraw money at the minimum distribution. (That’s explained in the following section.) With the stock transfer choice, though, she has to pay tax on the cost basis of the stock right away, even if she does not sell the stock for a while.
There are two other benefits, though, to the stock transfer. Not only does Jane get capital gains tax rates on the stock’s gains, but she is in complete control of when she sells the stock. As we’ll learn in the following section, the IRS has minimum distribution requirements for money in your 401k or an IRA. As there is no minimum distribution requirement for the company stock you withdraw, you can hold it so long as it suits you.
If you die while holding the stock, your heirs will inherit it with no further tax due on the capital gains. That’s called “stepped up basis.” It doesn’t make any sense, but it’s the law. Although it doesn’t help you out, your children will be better off after your funeral.
This all sounds fairly complicated, especially as the perfect answer depends on a lot of assumptions like future tax rates, rate of return on investments in the future, how long before you will sell the stock, and so forth. I’ve done the hard part for you though, running many simulations of different circumstances. Surprisingly, they all came to pretty much the same conclusion:
- If the cost basis of your company stock is less than 40 percent of the stock’s current value, then you’ll probably be better off withdrawing the stock separately.
- If you are in the highest tax bracket (33 or 35 percent), you’ll probably be better off withdrawing stock if your cost basis is 60 percent of total value or less.
- If you are going to have more than enough money for your retirement, and you want to leave as much as possible to your heirs, then you’ll probably be better off withdrawing stock regardless of the tax basis.
The other issues only make a small difference. Also, if you are near the breakeven point (40 percent for most people, or 60 percent for the highest income brackets), then don’t worry. There is hardly any difference between the two possibilities if you are in the neighborhood of the breakeven point, so don’t bother sharpening your pencil. Unless, of course, you are one of those people who insists on squeezing every last penny out of your investments.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
» Lesson 7: Your Retirement
Lesson 9: Your 401k, Your Other Assets, and Your Life
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