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Lower Taxes with Net Unrealized Appreciation

Nov 22, 2016 3:32:43 PM
Author: Hanson McClain



Have you ever heard of Net Unrealized Appreciation? If you have a 401(k), it could save you a lot of money and stress down the road.

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Read Full Audio Transcript:

Scott H: Pat, welcome to Hanson McClain.

Pat H: Thank you, guys. Yes, I am very old.

Pat M: And just for the rest of the listeners, I worked at another firm with Pat Henry 25, 26 years ago when I first started in the business, and we shared an office. Pat and I did.

Pat H: That's right, we started there in 1989. So I've been doing this a while.

Pat M: Yeah, good times.

Scott H: You have been doing this a while.

Pat M: Good times. Wake the kids, call the neighbors. Anyway, let's move on to the meat of the story.

Scott H: Yeah, we’d like to hear something, an advisory story, that’s interesting or out of the norm, and the idea is for you to think, "Hmm, I wonder how this might apply to my own life."

Pat H: Yes, thank you. I think this a little bit out of the norm of what we usually do. I've been working with this client about two and a half years before her retirement. And at the end of last year, just trying to get her ready and make sure that she was doing all the things that would create a successful retirement. At the end of last year, she received an offer of a year's pay to retire a little bit early from her company. She worked for a large energy company down in the Bay Area. She decided to take it. She was in a good financial position.

She retired at the end of last year and at the beginning of this year, we were taking care of setting up her assets. She didn't need any income at the time because she had the severance package that was going to pay her for about a year. She had a large 401(k) balance and in the 401(k) balance, about a third of it was invested in company stock. The company stock had a relatively low-cost basis in it.

One of the things that we wanted to look at was how could we get those dollars out of the 401(k) and reduce her tax liability as much as possible because she is going to start taking income next year and so we wanted to have funds available for her to start generating money.

So what we decided to do is we used what's called the net unrealized appreciation. It's a strategy where you can transfer your company stock out of the 401(k) into an after-tax brokerage account. And at the time you do that, you're going to pay ordinary income taxes on the cost basis, but any of that appreciation above the cost basis is taxed at capital gains rate when you decide to sell it. So you do not have to pay the taxes on that immediately. The other benefit of it is it's all taxed at long-term capital gains rate no matter when the capital gain was earned.

Pat M: So, Pat, for the rest of the listeners, they're thinking...

Scott H: Besides the two of us listening to Pat Henry talking.

Pat M: That understands what he's talking about, it's kind of a crazy concept, but if you work for a company and these are typically Fortune 500 companies...

Scott H: And we've done this a number of times, so it's not an everyday thing.

Pat M: But you come across it, you come across it, and a good advisor will actually point it out to the client.

Scott H: A good advisor.

Pat M: A good advisor. It worked well in this situation. You've been meeting with this person a number of years prior to her retirement.

Scott H: You said it was roughly a million dollar account balance, right?

Pat H: Correct, this is about a little over $300,000 stock position.

Scott H: And what was the cost basis roughly?

Pat H: Just right under $100,000.

Scott H: Okay.

Pat M: So what that means is there's $300,000 in stock, not units but stock in this person's 401(k), they could sell that, they could take that stock out, take it out, have it distributed, and pay taxes on the hundred thousand, the $200,000 that was unrealized. The unrealized appreciation would not have to be recognized until they sold that, and then it would be taxed at a more favorable capital gains rate versus ordinary income tax.

Pat H: Right. Based on her income bracket, we figured it was going to save her eventually about $30,000 in taxes.

Pat M: Okay. So there's two risks here, right?

Scott H: Plus a couple of other things. One is when the stock is held on the outside, the dividends that are paid from the company are qualified dividends at a lower tax rate. Second, you do not have to worry about required minimum distribution. I mean, she had pretty sizeable account balance already.

Pat M: So, there are two risks, right? The one risk is that they change tax law and make capital gain higher taxes than ordinary income, and then this whole exercise would have been for not, but you wouldn't have hurt yourself. And the other risk is that you have a...

Scott H: The stock tanks.

Pat M: You have a highly concentrated stock position. But you can...what's that?

Pat H: I was going to say with this person, it was great because it's a large position but it's only about 15% of her overall portfolio.

Pat M: Perfect. If it was highly concentrated as a percentage, let's say 40% or 50% of someone's portfolio, you can actually buy financial instruments to help mitigate some of that risk.

Pat H: And the other unique situation about using this strategy is once you start, you do have to liquidate the entire account within 12 months. So what we did is we, in January, rolled out her funds and cash and positions in there over into an IRA, but because of the company, we felt the stock was underperforming based on what was happening in the economy. And this isn't something we would do all the time, but just looking at this, we said, "I think this will probably do well going throughout the year." We left the stock in her 401(k) until about a week and a half ago, and then we just now transferred it over and the stock grew about $16 a share over that time period. So now all of that capital gain will be treated as long-term capital gain no matter when she decides to sell the stock.

Pat M: And the thing to remember, it has to be in shares. It can't be in units.

Scott H: It can't be a phantom fund.

Pat H: Correct.

Scott H: All right. Well, thanks, Pat.

Pat M: And thanks for being part of the Hanson McClain team for the last 12 years.

Scott H: Yes.

Pat H: Oh, it is my pleasure, gentlemen.