Should you hold your own employer’s stock in your 401K? The conventional answer, and my default response, is… no. However that is a topic that is worth some discussion.
While I wouldn’t encourage you to buy your employer’s stock in your 401k plan it doesn’t necessarily follow that you should immediately sell it if you already own it. This is especially true if you have held it for a long time and are VERY near retirement and getting ready to start taking distributions or roll it into an IRA.
The reality is, many people DO own stock in their own employer and you may be one of them. What are the pros and cons and why should you not necessarily sell employer stock that you currently own?
Buying Employer Stock in a 401k
A lot of people invest in their own company stock in their 401k. We all take comfort in things we are familiar with so it sometimes feels like the natural choice to invest in our own employer.
After all, you probably aren’t as familiar, or comfortable, with the other investment choices in your 401k. The mutual fund options in your 401k hold hundreds of other companies, and some of them you’ve never heard of.
But you do know your employer. You may have worked there for decades and understand the business environment and company culture. It’s that familiarity that draws so many people to their own employer’s stock.
There are also retirement plans like stock bonus plans ore ESOPs that are specifically designed for you to own employer stock. If you have one of these types of plans you’ll definitely own your employer’s stock and can also take advantage of the tax benefits discussed in this article.
So why might you want to avoid holding too much of your employer’s stock in your 401k?
There are several downsides to buying stock in your own employer.
- If you are buying your company stock, you may end up with a heavily concentrated position. Your company stock will end up being a disproportionately high fraction of your 401k and you won’t be properly diversified.
- Your TOTAL risk is concentrated in one company. When you heavily invest your retirement savings in your own employer you would be hit especially hard if something bad were to happen. Imagine your employer going out of business. Not only would you lose your job, and with it your ability to pay bills and buy food, but you would lose your retirement savings too. This is the classic case for not investing in your own employer.
These two reasons alone should be enough to encourage you to diversify your retirement savings.
However, if you have accumulated employer stock in your retirement plan you may be able to take advantage of special tax treatment that applies to employer stock in qualified retirement plans. Again, this applies to stock bonus plans and ESOP plans as well as 401ks.
Tax Benefits of Employer Stock
If you have recently retired or are planning to in the very near future, you’ll want to consider the tax benefits of employer stock that you have in your 401k. Before you sell your stock or roll your money into an IRA you’ll want to make sure you understand these unique tax rules.
If you have held your employer’s stock for a long time, you might be able to save quite a bit on taxes if you plan your withdrawals correctly.
Retirement Rollovers and Withdrawals
First, consider how withdrawals from a retirement plan normally work when you retire.
Normally you would roll your 401k into an IRA to take advantage of better investment options, get professional help, or simply because your 401k plan requires it when you retire. You can handle the investments you roll over in one of two ways:
- You roll your investments “as-is” into the IRA. The stocks, bonds, and mutual funds you hold in the retirement plan are transferred into the IRA.
- You sell everything and move the cash. You purchase new investments in the IRA.
Then, you would withdraw from the IRA by selling a portion of the investments and withdrawing the cash.
In a traditional IRA, your withdrawals from the IRA are taxed at your ordinary income tax rate.
We will revisit this process in a moment when we discuss distributing employer stock.
Net Unrealized Appreciation
There is a tax rule that gives you a big break on employer stock in your retirement plan. The break comes from a concept called net unrealized appreciation, or NUA.
Here is how it works…
When your investments increase in value, the difference between what you paid for them and what they are currently worth is called a capital gain. Say you bought a share of your employers stock 15 years ago for $20 and it is now worth $65. You have a capital gain of $45.
- If you have not sold the stock, you have an unrealized capital gain.
- If you sell the stock, you have a realized capital gain.
Distribution of Employer Stock
Now, assume you have that stock in your qualified retirement plan with an unrealized capital gain. You haven’t sold it yet. When you retire, you can take advantage of the NUA rules to reduce the tax bill on your withdrawal.
When you retire and want to withdraw your money and investments from your retirement plan:
- Roll that stock into a taxable investment account. This is key.
- If you sell the stock and move the cash, you lose the tax benefit.
- If you roll the stock into an IRA, again, you lose the benefit.
- You MUST move the stock itself into a taxable account. This is called an in-kind distribution.
- You can do whatever you want with the other investments in the account. If you hold some mutual funds as well, for instance, feel free to roll those, or the cash from selling them, into an IRA.
When you withdraw the stock from your retirement plan and move it into the taxable account you will owe ordinary income tax on the original cost of the stock. In this case, you’ll owe income tax on $20.
But that stock is worth $65, what happens to the other $45?
You won’t owe any taxes on the remaining unrealized capital gain (appreciation) until you sell the stock. At that point, you’ll owe taxes at the long-term capital gains rate. This can be a big deal because long-term capital gains tax rates are more favorable than ordinary income tax rates.
For 2019, Long-term capital gains tax rates are:
|Rate||Single||Married Filing Jointly|
|0%||Up to $39,375||Up to $78,750|
|15%||$39,376 to $434,550||$78,751-$488,850|
|20%||Over $434,550||Over $488,850|
… and income tax rates are:
|Rate||Single||Married Filing Jointly|
|10%||Up to $9,700||Up to $19,400|
|12%||$9,701 to $39,475||$19,401 to $78,950|
|22%||$39,476 to $84,200||$78,951 to $168,400|
|24%||$84,201 to $160,725||$168,401 to $321,450|
|32%||$160,726 to $204,100||$321,451 to $408,200|
|35%||$204,101 to $510,300||$408,201 to $612,350|
|37%||Over $510,300||Over $612,351|
If you do it correctly, you’ll end up paying ordinary income tax on $20 and the lower long-term capital gains tax on $45.
What if I Sell the Stock and Withdraw Cash or Roll it into an IRA?
If you sell the stock while it is still inside your retirement plan and then withdraw the cash, that is simply a normal withdrawal. You’ll owe income tax on the entire $65.
NUA rules do not apply to IRAs. If you roll the stock into the IRA, you’ll pay ordinary income tax on any amount you withdraw from the IRA.
What About Capital Gains After I Move the Stock to a Taxable Account?
You may decide to not immediately sell the stock after you withdraw it from your employers retirement plan. If you don’t, the stock value will still fluctuate until you sell it.
Any additional capital gain beyond the unrealized capital gain at distribution is treated under normal capital gains tax rules.
Let’s say instead of selling that stock immediately after taking it out of your retirement plan you hold it. The price climbs to $80 and then you sell.
You would still owe ordinary income on the original $20 and long-term capital gains tax on the $45 unrealized capital gain at the time of distribution.
It’s the difference between the $65 stock price at distribution and the current $80 price, or $15, that we are discussing now.
Remember that capital gains are taxed as either short-term capital gains or long-term capital gains.
- Short-term capital gains are gains on assets held one year or less.
- Long-term gains are gains on assets held over one year.
Short term gains are taxed as ordinary income.
- If it has been less than a year since your rolled the stock out of your retirement account you’ll owe ordinary income tax on that $15.
- If it has been over a year, that $15 is a long-term capital gain and will be taxed at either 0, 15, or 20%.
Depending on your taxable income level and marital status, the difference between income tax rates and long-term capital gains tax rates can be significant.
When Should I use this?
Again, I wouldn’t encourage you to purchase a lot of employer stock in your 401k just to take advantage of this. The risk from a lack of diversification is too high.
However, if you are near retirement and are just now learning about that risk consider rolling your employer stock out to a taxable account before you sell it if you have large unrealized capital gains. You will likely end up with a lower tax bill.