For many years, SMI has warned against the dangers of holding too much of your employer’s stock in a 401(k) or other company retirement plan. It is simply too risky to depend on your employer for your current income and your retirement income.

Just ask former employees of Enron or Worldcom. When those companies imploded, thousands of people were suddenly out of work. And, because many of their 401(k) plan accounts were heavily invested in their employers’ suddenly worthless stock, they lost a substantial portion of their retirement savings as well.

Still, the drawbacks associated with investing in your employer’s stock may be somewhat offset by a little known and potentially advantageous tax break for those who do. This article will sort out the dangers and potential benefits of investing in your employer’s stock.

A little background

The number of employers that offer their stock as part of their retirement plans has been in decline for at least the past 15 years, owing primarily to a string of surprising bankruptcies from large, seemingly successful companies, such as the ones mentioned above.

Adding momentum to that decline was a 2014 U.S. Supreme Court ruling which said companies offering their own stock in workplace retirement plans would no longer be “presumed to be prudent” in doing so. The ruling has made such companies more vulnerable to lawsuits related to the performance of their stock. This, in turn, has led many firms to remove company stock from their 401(k) investment choices.

Even so, millions of people still own their employers’ stock in their workplace retirement plans. Fidelity-administered plans alone show more than 15 million people do, with some $400 billion invested in company stock.

If you own your employer’s stock in your workplace plan, our cautions still apply. We recommend devoting no more than 10% of your total portfolio balance to your employer’s stock.

At the same time, it’s essential to understand the potentially valuable “net unrealized appreciation” (NUA) tax break available to you, especially if (1) you foresee leaving your company sometime in the near future, or (2) if your employer announces plans to stop offering company stock in its plan.

Little known tax break, big benefits

Under normal circumstances, when you leave an employer, whether for another job or retirement, it’s a good idea to roll over your workplace retirement plan balance into an IRA. However, if your holdings include company stock, it may be more advantageous to roll some or all of that stock into a taxable account. That’s because the NUA tax break allows you to pay ordinary income tax only on your cost basis (the original amount you invested) of the company stock, while paying lower long-term capital gains rates on any gains.

Here’s an example. Let’s say you invested $10,000 in your employer’s stock within your workplace plan and it is now worth $100,000. If you rolled that money into an IRA, no tax would be due right away, but when you take withdrawals from the IRA, the full amount of those withdrawals would be taxed as ordinary income.

Alternately, if you rolled the company-stock portion into a taxable account, you may be able to save a lot of money on taxes. There are three pieces to this money-saving puzzle.

  • First, under NUA rules, you would owe only ordinary income taxes on your $10,000 basis in the stock.
     
  • Second, when you sell the stock (now or in the future), you would owe long-term capital gains tax (current maximum rate: 20%) on the remaining $90,000 instead of paying at the far less favorable ordinary-income tax rates (maximum rate: 39.6%). If you hold the stock and eventually have additional gains beyond the $90,000 NUA amount, those gains will either be short-term or long-term depending on how long you continue to own the stock after the distribution from the company plan (which is when the NUA amount was calculated).
     
  • Third, if you are under age 59½, you may also owe a 10% early withdrawal penalty on the basis amount of the company stock. If you take distributions from the plan of a company you left when you were at least age 55, you will not owe that penalty. If you’re still with your company and are at least age 59½, you won’t pay the penalty, but your company may not allow penalty-free distributions as long as you remain in service with the company (most larger companies do, but not all).

Even when factoring in the ordinary income taxes owed on your cost basis and potentially an early withdrawal penalty, rolling the employer stock portion of a workplace plan into a taxable account may still save you a lot on taxes, especially compared to rolling the money into an IRA and then beginning to take withdrawals soon.

To take advantage of the NUA tax break, you must take a distribution of your entire workplace plan balance in the same calendar year. You can roll some of it into an IRA (typically the portion not invested in your employer’s stock), and some or all of the portion invested in your employer’s stock into a taxable account.

Choose before the benefit disappears

If you own company stock in a workplace plan, either at a current or former employer, here’s one more important factor to be

aware of. Some companies are automatically converting such stock into other investments as they eliminate company stock as an investment option. It’s important to find out whether your company is among those that have started this process, or plan to. When this occurs, a deadline is typically announced in advance. Miss the deadline and you will miss out on the NUA tax break.

Plan carefully

Generally, it may be best to roll company stock from your workplace plan into a taxable account if you are in a high tax bracket and plan to sell the stock soon, either to use it for current needs or to diversify into other investments. Of course, you also need to consider whether you can afford the taxes you would owe on the basis, and the early withdrawal penalty, if it applies to you.

Unfortunately, it’s difficult to generalize about these scenarios, because the best decision depends on how much the company stock has appreciated since you bought it, your current tax rate, and so on. So before doing anything, you need to run the numbers. While some help for this exists online, if you don’t feel comfortable with your ability to do this accurately, it may be wise — particularly if your company stock balance is significant — to seek the guidance of a financial planner or CPA experienced in such matters.