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Taking Stock
By Karen Hube, January & February 2006
A big part of her 401(k) is invested in company shares. Should she sell or hang on to them?
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At a recent family reunion, Jeanne Hudson, 63, mentioned she has about one third of her 401(k) assets in her company's stock. From the reaction, you'd have thought she'd admitted to insider trading. Her relatives begged her to diversify, citing the now famous collapse of Enron in 2001, when many workers who had overinvested in company stock lost their life savings.
The advice caught Jeanne off-guard. Her company stock has been one of her best-performing investments over the long term, and there is no reason to believe its fortunes will change anytime soon. But Jeanne—who plans to retire within the year—is now wondering whether she should dump the stock to reduce her risk in retirement. She just can't afford to lose any of her $300,000 nest egg.
Congratulations, Jeanne. You saved yourself a bundle in taxes by not making any hasty decisions. While it's generally a bad idea to hold a large chunk of your money in a single stock, 401(k) participants within a year or two of retirement may be wise to hold tight, assuming their company is in good fiscal shape. The reason? A little-known 401(k) tax law that rewards owners of company stock.
Usually when you withdraw money from a tax-deferred plan, you owe income taxes on the full amount you take out. But here's something few investors realize: if you transfer all your money out of your 401(k) in a lump sum after retirement—and financial advisers recommend that you do transfer money out so you have more control over it—your company stock can get preferred tax treatment. You will owe income tax only on the cost basis of your shares (the amount they were worth when you acquired them). Later, when you sell them, the appreciated amount will be subject to capital gains tax rates. For people in the 28 percent tax bracket, the long-term capital gains tax rate is 15 percent; for those in the 15 percent bracket, the rate is 5 percent.
So upon retirement Jeanne should ask her company to transfer her shares of company stock into a brokerage account and to roll the rest of her money into an IRA. Of the $100,000 she holds in company stock, her cost basis is about $10,000 (companies provide this information) and her income tax rate is 28 percent, so she would owe a modest $2,800 in income taxes. After that, any time she cashes out company stock, she'll pay capital gains taxes.
The difference is huge, says Mark Cortazzo, a senior partner at MACRO Consulting Group, a financial-planning firm in Parsippany, New Jersey. For instance, if Jeanne takes $18,000 a year out of her portfolio and she earns an average annual 8 percent return, at age 89 she'll still have $322,905 in her accounts. Without the tax break, her portfolio would be worth just $233,236.
Many folks simply don't know about this tax break, or they find out about it too late. It's actually quite easy to make yourself ineligible—if you are over 591/2 and retired and you take any distributions from your 401(k), or you have already rolled your assets into an IRA, you lose the right to take it, says Cortazzo. Jeanne should work with a financial adviser experienced in 401(k) tax rules, because even the paperwork can be a pitfall. "The devil is in the details with this thing," says Cortazzo.
Karen Hube is a financial writer in Westport, Connecticut.
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