Should you invest in the stock of your own company through your 401(k) or other retirement plan? It makes perfect sense because you’re effectively betting on yourself.
To sweeten the deal, you might be able to buy the stock at a substantial discount. Go right ahead, but don’t put all of your eggs in one basket.
Best of all, you may be in line for a future tax bonanza.
Strategy: When you’re ready to retire, keep the payout in the form of company stock. Don’t convert it to cash or other securities.
Here’s why: Thanks to a giant loophole in the tax law, you only have to pay tax on the original cost of the stock. In other words, there’s no tax due on the appreciation in value—called the “net unrealized appreciation” (NUA)—that has occurred from the time you acquired the stock. The payout comprising the company stock is 100% tax-free until, if ever, you sell your shares!
Icing on the cake: Any subsequent gain on the NUA is treated as long-term capital gain as long as you’ve held the stock for more than one year. Currently, the maximum tax rate on long-term capital gain is only 15%. (The maximum tax rate is scheduled to increase to 20% in 2013.)
Therefore, you can emerge a double tax winner: once when you leave the company and again when the stock is sold.
Example: Say you founded your own company a couple of decades ago. Over the years, you’ve acquired 20,000 shares of stock through your retirement plan. The shares are currently worth $1 million. The stock originally was $5 a share; now it’s valued at $50 a share.
If you sell the stock and take a cash payout, you’ll receive $1 million when you retire. Not bad at all. But the entire payout will be taxed as ordinary income. That means, assuming you’re in the 35% tax bracket in the year of retirement, you’ll have to pay a hefty federal income tax bill of $350,000.
Now let’s see what happens if you take a distribution in the form of company stock. You will be taxed at ordinary income rates on the original cost of $100,000 (20,000 shares at $5 a share). Therefore, your federal income tax bill is $35,000 (35% x $100,000). Then you can turn around and sell the stock at $50 a share for a total of $1 million (20,000 shares x $50 a share).
With a 15% capital gains rate, the tax on the $900,000 of NUA is $135,000 (15% x $900,000). Here’s how things look overall:
Original basis $100,000
Tax on basis $ 35,000
Tax on NUA $135,000
Total tax $170,000
Payoff: Taking this approach saves you a whopping $180,000 in tax on your retirement plan payout ($350,000 compared to $170,000).
In the past, Congress has threatened to close the gaping tax loophole for NUA, but so far it has managed to survive every challenge. Nevertheless, if proposals to eliminate or reduce this tax break are revived, which is a likely scenario, you may be encouraged to retire sooner rather than later.
Alternatively, you might choose to roll over a cash distribution into an IRA. This maneuver enables you to spread out tax as distributions are received over the course of time. However, the payments are then taxed at ordinary income rates. Saving grace: Usually, your top tax rate in retirement will be lower than your current tax rate for ordinary income.
Tip: IRA distributions are mandatory after you reach age 70½. In contrast, there’s no such requirement for the portion of a retirement payout comprised of company stock.
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