You've probably endured a lot of finger-wagging in the post-Enron era to diversify your 401(k) dollars.
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IN THIS PACKAGE
- Disciplined saver faces a big expense
- Seasonal slogans may not always peg investment truths
- A little money, lots of time can make teen a millionaire
- Tax strategy can save on stock distributions
- The savings game
- The Leckey file
- Getting started
- Spending smart
- Can they do that?
- Taking stock
- Approach to retirement can become filled with turbulence
- The week ahead
- Federal Income Tax
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When you leave an employer, you can take some or all of the company shares out of your account and deposit them in a taxable account, while rolling over the remaining shares and mutual funds into an individual retirement account.
You pay ordinary income taxes on the cost basis at the time the shares are distributed. But you pay long-term capital gains taxes, now at a maximum of 15 percent, on the appreciation when you sell the stock. You also create a pile of cash that isn't subject to required minimum distributions.
By contrast, you would pay ordinary income taxes, up to 35 percent for federal taxes alone, on the entire value of the shares when you start withdrawing them in retirement if you leave them in an IRA.
Fewer than one in 10 departing employees are taking advantage of the tax treatment, known as net unrealized appreciation, said Steven Feinschreiber, senior vice president of research for the Fidelity Research Institute, an offshoot of the Boston-based mutual fund and retirement plan giant.
Studying more than 250 Fidelity retirement plans, researchers estimated about 24 million Americans hold a combined $400 billion in company stock.
The 2.5 million people age 55 to 64 in that group hold about $40 billion in appreciated stock that might benefit from the better tax treatment, the company estimates. Fidelity also estimates that 60 percent of the 55- to 64-year-olds would benefit from studying the options under the strategy.
So why don't more workers take advantage?
"Most people have never heard of" net unrealized appreciation, said Feinschreiber, who wrote a report on the topic that can be found at www.fidelityresearchinstitute.com/pdf/nua_may2007.pdf.
Companies aren't required to tell departing workers about it, and most loathe putting themselves in the position of giving tax advice, said David Cantor, a workplace-retirement-plan expert with Mercer Human Resources Consulting in Charlotte, N.C.
In fact, many companies have loosened restrictions on holding company stock and encouraged workers to diversify, Cantor said.
Net unrealized appreciation can save you a bundle, particularly if you have highly appreciated stock that you intend to hold a long time. It can make sense even for younger workers who are changing jobs and plan to withdraw some cash.
Because of its complexity, though, consult a tax adviser, just to be sure the plan rollover is done correctly and that it meshes with your estate-planning wishes (there are caveats).
In general, here's how net unrealized appreciation works, according to a Journal of Financial Planning article by John Nersesian, managing director of Wealth Management Services at Nuveen Investments in Chicago (www.fpanet.org/journal/articles/2004_Issues/jfp0204-art7.cfm):
A departing worker notifies the retirement plan administrator in advance that he will take a distribution of all or a part of his company stock.
He will pay ordinary income tax on the cost basis at the time the shares are distributed.
"The difference between the basis and the fair-market value at distribution--the net unrealized appreciation--is taxed at long-term capital gains rates when the stock is sold," Nersesian wrote in the Journal article.
The net unrealized appreciation receives long-term gains rate, while any subsequent appreciation on shares held after the distribution is taxed at long-term or higher short-term rates, depending on the holding period.
For whom does the strategy make the most sense?
Generally, it is best for retiring workers in high tax brackets who have accumulated large amounts of appreciation on company shares, said Feinschreiber.
But it can benefit someone younger, despite early withdrawal penalties (remember, you are taking the stock out of a qualified plan and putting it into a taxable account). Those penalties apply only to the cost basis on the stock, not the appreciation.
A hypothetical 50-year-old in the highest tax bracket saved $24,000 by electing net-unrealized-appreciation treatment for a $100,000 company stock account that had a $20,000 cost basis, Fidelity said. That includes accounting for a 10 percent penalty.
For workers with very long investment time horizons who don't need immediate cash, it is typically best to keep the shares (or diversify into funds) in an IRA to receive the benefit of continued tax deferrals, experts said.
But for those who are going to raid their accounts for cash anyway, they might as well elect the best possible tax treatment, they noted.
E-mail Janet Kidd Stewart at firstname.lastname@example.org.
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