Listen to Scott and Pat discuss how individuals with employer stock in their 401(k), a profit sharing plan, or ESOP can avoid paying taxes with a smart tax strategy of Net Unrealized Appreciation.
Scott Hanson: Pat, you were alluding to rolling the 457 over to an IRA. And there is a strategy, a tax strategy. If you either currently work for an employer or have worked for an employer where you've had employer stock in your 401K or in your ESOP, you're going to want to listen to this.
Pat McClain: Yes.
Scott Hanson: So there's a strategy, what's known as "net unrealized appreciation." Here's where this comes into play. You've got an employer savings plan at work, a 401K, an ESOP, profit-sharing plan that has employer stock in the plan. You are an owner of the shares in the company.
When you retire, if you transfer that 401K or other profit-sharing plan, you can roll it to an IRA, and it's a tax-free event for you. There are no tax consequences for doing that, and almost everything you read will talk about the benefits of an IRA rollover and why it makes sense. If you just do that, you are going to be giving up a potential, phenomenal tax savings.
Pat McClain: Which is this net unrealized appreciation of that stock in the 401K.
Scott Hanson: So, here's how this works.
Pat McClain: I should point out it has to be stock. It can't be units. So, some 401Ks you think you own stock because it shows, but you own units that are representative of the stock, not the stock itself.
Scott Hanson: Yes, you own some derivative, it's not the actual shares. You actually have to be an owner, have direct ownership inside the company. But, here's how it works.
Pat McClain: In your 401K.
Scott Hanson: Let's assume that you have stock valued at $100,000 in your 401K, and let's assume what you paid for those shares over the years, maybe your contribution including what the employer's contributions were, let's assume that it was $10,000. Okay, so let's assume you work for a company that's done phenomenally well, the stock price went up in a huge manner. So, it's $100,000 worth of stock in the company retirement plan, and your cost basis, what you paid for it, is $10,000.
You roll those into an IRA and then pull the $100,000 out. That $100,000 will be taxed to you as ordinary income, whether it's rolled in or you just take it. Now if instead you say, rather than rolling these into an IRA, "Company, please take all my excess dollars in those funds, transfer that to my IRA, but take the shares and just send them home to me."
Pat McClain: Send them directly. Do not roll the shares over.
Scott Hanson: And, although you say you're required to withhold 20%, you really don't have to on the stock. So if you think you do, let me talk to a supervisor. I'm going to nail this, get this thing rammed through.
Pat McClain: You've done this before.
Scott Hanson: Yes, have the shares transferred directly to you. When the shares are transferred directly to you, what's taxable to you is not the $100,000 value, but the $20,000 cost basis.
Pat McClain: What you paid for them.
Scott Hanson: And you're saying, "Well, why would I want to incur a tax liability?" Well, when you subsequently sell those shares, you'll have favorable capital gains treatment.
Pat McClain: Not ordinary income.
Scott Hanson: Plus, let's say it's a stock that produces a dividend, you can hold the shares. The stock will pay out a qualified dividend to you, which is favorable tax treatment, not ordinary income. So, the tax ramifications regarding this, they're phenomenal.
Pat McClain: So, if you're listening and you are saying, "Well, this kind of makes a little bit of sense," I would tell you it is filled with land mines. Don't do it alone.
Scott Hanson: Yeah, yeah, yeah, don't do it alone (because it’s easy to make a costly mistake).
Pat McClain: Your company is going to mess it up.
Scott Hanson: Yes, yes, yes, yes. Every time I've done it with help, too.
Pat McClain: We have never had one go smoothly, but we do them.
Scott Hanson: Yeah.
Pat McClain: Not every day, because they're kind of a rare thing but...
Scott Hanson: The right situation.
Pat McClain: ...when the right situation. But when we do them, we tell the clients, "Look, don't get mad at us, your company is going to mess this up. They are so rare, no one knows how to actually handle them." But it's in the tax code and it's got incredible tax advantages and it's, if you will, a legal loophole.
Scott Hanson: Net unrealized appreciation, I don't know if it's a loophole.
Pat McClain: Well, you know what loopholes are, Scott. It's a long slit in the side of a castle that you shoot an arrow through.
Scott Hanson: Thank you. We discussed this in the show a couple weeks ago.
Pat McClain: I was in Ireland. I went to a castle and saw the loopholes.
Scott Hanson: You did.
Pat McClain: I did, recently.
Scott Hanson: Okay, Pat goes to Ireland.
Pat McClain: It was exciting.
Scott Hanson: Pat finally takes a vacation and goes to Ireland for a couple of days. How long did you spend in Ireland?
Pat McClain: Three days.
Scott Hanson: Three days, that sounds kind of like a McClain vacation. The McClains went to a family vacation years ago. They were supposed to be gone two weeks to Europe, right?
Pat McClain: Yeah.
Scott Hanson: It was four or five years ago. He came back early. I'm like, "What are you doing home early?" "We were just done." "What do you mean?" "Yeah, we're done."
Pat McClain: We were done.
Scott Hanson: "Weren't you on a cruise?" "Yeah." "But, you left early?" "Yeah, we're done."
Pat McClain: We were done. I'm not...The idea of cruising is much actually...Anyway, so these loopholes.
Scott Hanson: Anyway, the concept is net unrealized appreciation. We highly recommend if you have employer shares in your retirement plan, before you retire, before you roll those dollars over into an IRA, talk with a qualified advisor, a Hanson McClain advisor or somebody else who's qualified in this matter, to have a discussion regarding this. You're going to want to do this correctly, because once it's in the IRA...
Pat McClain: You can't do it.
Scott Hanson: ...this tax benefit's gone.
Pat McClain: And it has to take place in the transfer from the 401K.
Scott Hanson: And it could mean tens of thousands, if not hundreds of thousands, or millions of dollars in tax savings to you, depending on how much company stock you've got.