Clients and prospects inquire on a regular basis about their options for 401(k) balances that remain at their previous employer. Generally, the rule-of-thumb answer is to roll the 401(k) into an IRA. An IRA rollover allows a person to consolidate retirement plan assets in one location and it also provides the opportunity to invest in a wider variety of investment options. However, with any rule there are exceptions that should be considered. One such exception which should be considered prior to completing an IRA rollover relates to net unrealized appreciation.
Net unrealized appreciation in this case refers to the appreciation of an employer's company stock that is held within an employee's 401(k) account. If an employee is over age 55, they can withdraw the stock directly from the 401(k) and pay capital gains tax on the unrealized gain of that stock. If the employee is under age 55, they will also owe and additional 10% penalty. The primary benefit of capital gains tax rates is that they do not exceed 15%. Had the stock been rolled into an IRA and then withdrawn, the tax on the gain would have been calculated using the taxpayer's ordinary income tax rate which can be as high as 35%. The net tax benefit is a savings of up to 20% in the tax rate applied to the gain on the stock.
For example, assume that an employee is in the 35% tax bracket and has $100,000 of employer company stock in their 401(k) plan; and further assume that the $100,000 consists of $20,000 of employer/employee contributions. The remaining $80,000 is appreciation of the stock value referred to net unrealized appreciation. The employee requests an in-kind distribution of the company stock instead of rolling the company stock into an IRA. The employee will owe ordinary income tax at 35% on the $20,000 of contributions ($7,000) and capital gains tax of 15% on the $80,000 appreciation ($20,000) resulting in a total tax bill of $19,000. It is also important to note that the taxpayer cannot take a partial distribution of the company stock.
If the employee had instead rolled the $100,000 of company stock into an IRA the total amount would be taxed at ordinary income tax rates, 35% in this case, resulting in a tax bill of $35,000. The total tax savings of utilizing the net unrealized appreciation strategy in this example results in a total tax savings of $16,000 ($35,000 - $19,000).
Another consideration that should not be ignored associated with rolling the stock into an IRA is that any tax due will continue to be deferred until the value of the company stock is actually distributed from the IRA. There are situations, such as the desire to pass money along to heirs, that will make the IRA rollover more attractive.
A final negative consideration is that holding a large amount of company stock can adversely impact an investor�s ability to adequately diversify their portfolio. Enron is but one scenario where having a disproportionate share of your investment portfolio in one security resulted in devastating consequences.
One final consideration is that once an IRA rollover has taken place, it cannot be undone. So crunch the numbers prior to making a decision as to which approach is best for you.