Why should you distribute shares of company stock from your 401(k) instead of rolling them into an IRA? Many people are fortunate to own shares of company stock in their employer-sponsored retirement plans, including 401(k)’s. Often, these shares have been acquired over many years, and constitute a substantial portion of the overall retirement account balance. Many financial professionals will encourage employees to roll over company shares into an IRA, either during their working years as an in-service distribution, or after retirement. You also have the option of distributing the shares out of your plan. A good advisor will explain the tax implications related to company stock and work with your CPA to calculate how much you stand to gain or lose. You should also review this option any time you change employers during your career, as the potential savings can be significant over the years!
Let’s say you have $300,000 worth of company stock in your 401(k) with an original cost, or basis, of $100,000. The gain in value is referred to as net unrealized appreciation – $200,000 in this example. If you roll the shares into an IRA, when you later sell them and take cash as a distribution it will be taxed as ordinary income. If you distribute the shares from your 401(k) and continue to hold them, the NUA will not be taxed until you sell the shares, and will be taxed as a long-term capital gain. In our example, let’s assume you are in the 28% tax bracket. The potential tax on the $200,000 NUA if you roll the shares into an IRA is 28% of $200,000, or $56,000. If you distribute the shares and hold them, the tax on the $200,000 NUA once you sell the shares is subject to the long-term capital gain rate of 15%, or $30,000. In this example, we have created a savings of $26,000! Once you roll company shares into an IRA there is no way to reverse it, and you lose the opportunity to utilize the NUA strategy.
The potential savings can be significant, especially if you have a substantial NUA and are in a very high tax bracket. Although you are immediately taxed on the amount of the basis on the shares received, the deferred savings can be well worth it. Any gain above and beyond the NUA amount will be treated as short-term or long-term depending on how long you hold the shares after the distribution. Everyone’s situation is different and the tax code is always subject to change, so be sure to consult with your CPA. As always, feel free to contact us with any questions!
© 2016 Pawleys Investment Advisors, LLC. All rights reserved.
Last week, a client asked us to review the choices within her 401(k) plan at work to identify the best investments available. The line-up included 9 different funds and also company stock. There is a pending buy-out of the company, so when we initiated the review of the stock we anticipated that the stock would be trading at parity with the buy-out price. The buy-out offer contains a combination of cash and shares of stock in the acquiring company. The board of directors and shareholders of both companies have already approved the transaction, which is scheduled to close in the next several months.
Much to our surprise, the company stock of our client is trading at a 35% discount to the buy-out level. Clearly, the market does not believe the transaction will complete. The merger is being reviewed by the Department of Justice for anti-trust issues. Recently, several high-profile mergers have fallen apart amidst government anti-trust concerns, including Office Depot & Staples, Sysco & U.S. Foods, and Halliburton & Baker Hughes. We classify a pending buy-out which may be blocked as a binary event. There are only 2 possible outcomes: either the companies will merge, or they will not. Let’s be clear before we continue the story – the client was not in possession of material non-public information, and the trading window on the company stock for employees was open.
Typically, the best way to participate in a binary event is to place a straddle with option contracts. This position is constituted by calls and puts with the same strike price and expiration date (which in this case would be just past the scheduled close date of the merger). If the deal falls through and the stock falls or if the deal closes and the stock rises, the straddle holder profits. Philosophically, we do not advocate the use of derivatives, so what did Pawleys recommend to the client?
As we reviewed the stock, we like their fundamental financials and the valuation of the stock, and were happy to recommend a long position to the client regardless of the outcome of the pending merger. But what if the client is not confident and wants to enter with a more conservative strategy? The client commits an amount of cash to the strategy and we use 50% of the cash to buy the stock. If the deal closes, our profit is limited since we did not initially invest the full amount of cash. But if the deal falls through, we take the remaining cash to add to the long position, averaging down the cost basis, and hold the stock. This is how Pawleys trades a binary event in a more conservative way. Ultimately, we went all-in as we feel the stock is high-quality and want to own it even if the deal fails.
© 2016 Pawleys Investment Advisors, LLC. All rights reserved.
Sometimes we head a bit off track, but ultimately end up turning back in the right direction.
Momma Loggerhead Turtle Tracks on Litchfield Beach – Pawleys Island
These tracks are left behind by a loggerhead turtle that came out of the ocean to lay her eggs up in the sand dunes. Happy Camper and I took this picture the morning of 6/07/2012 on South Litchfield Beach near Pawleys Island. Volunteers from S.C.U.T.E. (South Carolina United Turtle Enthusiasts) help monitor turtle nesting activity and are dedicated to sea turtle conservation in Georgetown and Horry Counties. The straight track is from her leaving the ocean and heading to the dune, and her tracks returning to the water have the zig-zag.
Help protect the turtles and their nests! Please keep lights out along the beach at night so turtles do not get disoriented, fill in holes on the beach and do not leave furniture out overnight (they can become trapped or entangled), and do not disturb nesting turtles (they may become frightened and dump their eggs into the ocean which makes them unviable). Here is a good lesson for investors to avoid potential pitfalls and focus on your objective…and if you get off track, no need to fret, you can easily get back on course! Learn more about the turtles here:
© 2012 Pawleys Investment Advisors, LLC. All rights reserved.