Company Stock Choices When Leaving Your Job

By Clifton Linton
Senior Writer

Editor's note: The "Estate Plans" section of this article was updated Nov. 22, 2002, to include information about the taxation of net unrealized appreciation in inherited company stock.

The dangers of holding company stock in a retirement portfolio were exposed by the Enron and WorldCom meltdowns. Yet many American workers won't sell theirs, figuring that the same thing can't happen to their employers.

Others can't sell their shares because their employers' plan rules won't let them.

Either way, many Americans may leave their jobs with substantial holdings of company stock. When they do, they will need to decide whether to exchange the shares for cash and roll the money into an IRA, roll the stock shares into an IRA, or to take the stock shares out of the tax-deferred account.

It's not an easy choice to make. If you take the shares, you may be able to take advantage of a tax break the IRS makes available only to holders of company stock. But you also need to consider how a large holding of a single stock will affect your portfolio.

Company Stock Tax Break
Before going any further, let's talk about stocks, losses, profits and taxes outside of a tax-deferred savings account.

If you make a profit on a stock trade, you will owe capital gains taxes. If you lose money, you can deduct a portion of that loss off your taxable income as a capital loss.

The nice part about long-term capital gains is that they are taxed at a rate less than your income tax rate. But, to qualify for the long-term capital gain tax rate, you must hold the investment for more than a year.

Capital losses or gains are calculated by comparing your acquisition price (known as your basis) against your sale price. Note that we used the term acquisition price. That is because people don't always get stock by purchasing it. Sometimes they receive it as a gift, or they inherit it, or it is made as a company contribution to their 401k plan.

Keep this discussion in mind as we examine the tax break available for company stock.

Normally, because 401k contributions are made on a pre-tax basis and because all earnings grow tax deferred, withdrawals are taxed as ordinary income. But, the IRS adds a little wrinkle to the way it levies taxes on company stock held in a retirement plan.

Here's how: you will owe income tax on the value of company stock at the time you acquired it (not at the time of distribution), whether it was held in a 401k plan or in an employee stock ownership plan (ESOP). You will pay capital gains taxes on any appreciation above your basis and income tax only on the basis.

The reason you pay only on the basis is because, when distributed to you, "the stock comes out at the plan's cost," said Mary Kay Foss, a certified public accountant with Marzluft, Giles, Tulis & Foss CPAs Inc., in Danville, Calif.

Hence, it is possible to have a basis different than the current market price. And, if your basis is below the current market price, you can get a tax break on the appreciation above the basis.

This tax break is only available if you take your company stock as shares in a lump sum when you leave your job, Foss said.

A rough way to calculate the tax break's value is to compare the basis to the price at distribution. The greater the difference between the two, the more attractive this tax break becomes, said Ted Benna, creator of the first 401k plan and president of the 401k Association.

Here's an example:

Suppose you work at ABC Co. and participated in the 401k for 20 years. Your employer makes its 401k matching contribution as company stock.

You reach retirement and have 1,000 shares of company stock in the plan.

Before leaving your job, you check with your employer and find that your basis is $25 a share. (Your employer must tell you this information.) Meanwhile, ABC Co. is trading at $50 a share on the stock market. In this case, if you take the shares you will owe income tax on 1,000 shares at $25.

Compared to owing income taxes on the entire stock distribution ($50,000), you owe it on only half ($25,000). So, this tax break sounds like a pretty good deal. If you immediately sell the shares, you will owe capital gains taxes on the difference between your basis, $25 a share, and the current price, $50 a share.

But, remember that we selected numbers to make a point. Your situation may be different. If the current value exceeds the acquired value by only 10 percent, for example, this tax break may not be worthwhile compared to rolling the stock or the proceeds of a sale into your IRA. If your stock acquisition price is at or above the current market price you may not get any tax break by taking a distribution of the shares.

If the current price is below your basis, and you take the shares, you will owe income tax on the lesser of your basis or the current market value.

Decision Process
While the prospect of getting a company stock tax break may look enticing, don't focus only on this when deciding what to do with your stock.

You also need to consider its investment impact.

When deciding what to do with company stock, "focus on the investment aspects first," suggests Bernard Kleinman, CPA with Eisner LLP, an accounting firm.

But, being dispassionate about company stock can be tough. It isn't an average investment.

Financial planners generally discourage retirees (and others) from holding a large amount of a single stock. That's because it can raise your portfolio's volatility, meaning it is riskier, at a time when you probably want to reduce risk.

"If you want to diversify it is smart to roll (the stock) over into an IRA," said Philip Cook, a CFP based in Torrance, Calif. You can roll the stock into an IRA, sell it and diversify your portfolio. Or, you may be able to sell the shares while they're in the 401k plan and receive a cash distribution, which you can then roll into an IRA and use to purchase a diversified portfolio.

But, many company-stock holders are reluctant sellers.

Kent Noard, an enrolled agent and CFP practitioner with Sterling Wood Financial, LLC, of San Mateo, Calif., often has to work hard to persuade clients to sell their company stock. Why the resistance? "It has sentimental value," he said.

That makes it hard to sell even when selling is the best course of action.

Remember, you can sell your stock and roll the proceeds into an IRA. Then you can diversify your investments. By rolling this money into the IRA you continue to take advantage of tax-deferred growth of your savings.

Still, if selling your company stock seems hard to do, one way to convince yourself of the best course of action is to run some numbers. Check to see if the company stock tax break is really worthwhile. It may turn out that taking the cash and rolling it into a tax-deferred account is more valuable in the long run than the tax break you get today. Ask an accountant and a financial planner to help you create a strategy.

"All too often what I see is people doing something based on what someone else did," Noard said. You need to do what is best for your situation, he adds.

Options and Outcomes
Here's a brief look at your options based on the tax and investment impact.

Tax impact

• If you take the company stock as shares you will owe income tax immediately on the acquisition price of the shares you receive but only capital gains taxes when you sell the stock.
• If you roll over the stock, or cash out and roll the money over to an IRA, there is no immediate tax bill. However, your withdrawals will be taxed at the higher income tax rate. You will continue to benefit from tax-deferred growth of your investment.

Investment impact

• If you take the company stock as shares, you may have to adjust your retirement portfolio's investments to keep its risk level in check. Remember, a large holding of a single stock adds significantly to your portfolio's risk level.
• If you roll over the stock or cash out and roll the money over to an IRA, you can diversify your portfolio, reducing your risk.

Estate Plans
If you won't need your company stock to support you through retirement, company stock has a nice estate planning benefit.

Any stock you pass on to an heir gets what is called a step-up in basis when you die. That means the stock's basis is recalculated to the price at the time of your death. Your heirs will owe capital gains taxes on any price increase after you die.

They may owe additional tax if your stock has what is called net unrealized appreciation (NUA). NUA is the gain from the time you acquire the stock until the time it's distributed from the plan. If you then hold on to the stock and pass it on to your heirs, they will owe long-term capital gains tax on the NUA when they sell the shares.

Here's how it works:

Suppose you acquired the stock in the plan at $15 a share. At the time of distribution, the stock was valued at $20. Your stock has an NUA of $5 a share.

Now suppose that when you die, the stock is worth $50 a share. Your heirs receive a step-up in basis from $20 to $50 without having to pay tax on that gain. However, they will owe long-term capital gains on $5 a share, the NUA, when they sell the stock.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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