You’ve been very careful with your 401k and IRA.You’ve been very careful with your 401k and IRA. You thought you did everything right. But ask yourself two questions:
If your answer to both questions is yes, there’s a strong chance you could make IRA Critical Mistake #6 in THE IRA CRITICAL MISTAKES series.
How so? Read on!
After a sharp decline in the price of the employer stock inside your 401k, IRA Critical Mistake #6 is failing to consider selling the employer stock within the plan, then repurchasing it right away, to potentially lower the cost basis.
The lower the cost basis of your 401k employer stock, the more likely the stock will become eligible for special tax treatment that could potentially save you a lot of money in taxes.
Why is this a mistake? What do you risk losing if you make this mistake?
If you are a candidate for the special tax treatment, and you don’t consider selling your 401k employer stock after a sharp decline, you might forfeit the ability to receive this special tax treatment that could allow a portion of your 401k employer stock to be taxed at a much lower rate.
To preserve the ability to receive this special tax treatment, specific steps must be followed before selling 401k employer stock.
The case study below shows the impact of selling 401k employer stock before these specific steps are taken.
If you subsequently withdraw the $1,000,000 from your 401k, and are 59 ½ or older, the entire withdrawal would be taxed at the higher ordinary income tax rate of 37%, or $370,000. That’s a lot of tax.
Is it possible for a portion of the employer stock in your 401k to be taxed someday at the lower 20% long-term capital gains rate rather than the higher 37% ordinary income tax rate?
Yes, it is! The strategy to accomplish this feat is a little-known provision in the tax code called “Net Unrealized Appreciation (NUA)”.
It works like this.
Assume you purchase $100,000 of employer stock in your 401k. This $100,000 is called your “cost basis”. Assume your $100,000 of employer stock grows in value to $1,000,000, meaning a gain of $900,000. Inside a 401k, this gain is called “Net Unrealized Appreciation”. Net Unrealized Appreciation is a tax break that allows a portion of your 401k employer stock to be taxed at the lower long-term capital gains tax rate rather than the higher ordinary income tax rate.
After your outside taxable brokerage account receives the employer stock from your 401k:After your outside taxable brokerage account receives the employer stock from your 401k:
The Net Unrealized Appreciation strategy works best when your 401k employer stock is highly appreciated. This happens when the cost basis of your 401k employer shares is low and the market value is high, as in our example above of a $100,000 cost basis, $1,000,000 market value, and $900,000 gain.
In the event of a sharp decline in the price of the employer stock in your 401k, it may be beneficial to consider selling the stock within the 401k plan and then repurchase it right away. Fortunately, “wash sale” rules do not apply when the sale for a loss has occurred only inside your 401k.
The purpose of selling 401k company stock after a sharp decline in price and repurchasing it right away is to “reset” or potentially lower the cost basis of the stock.
Be careful. Sometimes selling 401k employer stock after a sharp decline will not lower your cost basis.
Let’s review two scenarios.
After a sharp decline, if you can lower the cost basis of your 401k employer stock, you might improve your ability to enjoy the special tax treatment of implementing the NUA strategy in the future if your 401k employer stock price later rises.
Important Disclosure InformationApril 2023
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