Over SMI's 25-year history, we've frequently warned against the danger of holding too much of your employer's stock, typically within a 401(k) or other company retirement plan. We used to discuss it as one of the most common mistakes individual investors made. Those days appear to be drawing to an end.
The trend of employer stock being a prominent part of company retirement plans has been in decline for at least 15 years, owing primarily to a string of high-profile incidents at companies like Enron, Worldcom, and others in which employees lost both their jobs and the bulk of their retirement savings as their employer was caught by sudden financial distress. But there have still been individual companies that continued the practice, in spite of the overall trend.
Those days may be drawing to a close following the Supreme Court last year stripping away a key protection for company plans that offer company stock as an investment option. You can read the full details by following the link, but in a nutshell, the Supreme's decision has put companies in a precarious position if they continue to make company stock available to employees within their retirement plan.
Given that this court decision happened a year ago, it may seem like odd timing to write about this issue now. But the reality is that employers are increasingly winding down the company stock option within their plans, which means those who have company stock in their retirement plans are being faced with choices now that can have significant tax implications.
Fair warning — if you don't have company stock within your 401(k) or other retirement plan, you can stop reading now. The rest of this article really only pertains to those who have a company plan — current or former — in which they hold some company stock.
Those who do owe it to themselves to familiarize themselves with the "net unrealized appreciation" or NUA tax break. This Forbes article does an excellent job of summarizing the key issues.
The short version is this: when company stock is rolled out of an employer plan into an IRA, it loses a potentially valuable benefit (the NUA tax break). This break allows an owner to pay tax on company stock at long-term capital gains tax rates (which can be as low as 15%) rather than the ordinary income rates (which can be as high as 39.6%) that would otherwise apply to retirement plan withdrawals.
As a result, many people have kept 401(k) plans at past employers specifically to keep this NUA tax break alive. So it's crucial for these folks to find out (and stay informed) as to whether their company is among those who have started the process of removing company stock from their plan. When this happens, a deadline is typically announced, after which those company stock holdings are simply liquidated and invested in the plan's default option. Goodbye NUA to any shares that haven't been taken care of by that point.
Naturally, being a tax topic, the details can get pretty involved. But generally speaking, most people can simply roll company stock into a taxable brokerage account, while paying ordinary income tax (and a 10% penalty if younger than 59.5) on only the stock's original basis. Any appreciation is taxed when the stock is eventually sold at the lower long-term capital gain rates.
Bottom-line, if you have company stock in a current or former employer retirement plan, you need to read the Forbes article above and run the numbers on what approach makes the most sense for your situation. Otherwise, you may find a valuable tax benefit has disappeared without you even being aware it was happening.