I'm 65 with $500K in 401k and Own Company Stock: What's the Best Tax Strategy to Save $100K?

Casey Weade: Today, I'm going to talk with you about how to save $100,000 on $500,000 401k. If you have employer stock inside of your 401k and you're thinking about rolling that to an IRA, stop and watch this video before you proceed, or you could be leaving tens of thousands, even hundreds of thousands of dollars on the table.

Hey, I'm Casey Weade, CEO and founder here at Howard Bailey Financial, also a certified financial planner practitioner. I'm here to talk to you about taxes. We're going to be talking about 401ks. We're going to be talking about employer stocks. We're going to talk about something known as net unrealized appreciation, even charitable remainder trust. We're going to do all kinds of great things to save you money and keep more money in your pocket where it belongs.

I want to jump right into it, but I also want to say, I don't want you to misconstrue this as tax advice. You need to make sure you're consulting with your tax preparer, with your tax advisor before you make any changes to your own unique personal situation. What we're talking about today as we get into this, we're talking about net unrealized appreciation primarily. This is a special rule in the tax code that applies to employer stock that you might have inside of your 401k, and it could save you tens of thousands of dollars. We're going to see exactly how that works.

Before we jump into it, I just want to remind you how an IRA works. If you have a 401k and you roll those dollars over to an IRA, every dollar you take out of that IRA is going to be taxed at your highest marginal tax bracket. That's going to be ordinary income taxes. This special rule applies to employer stock, and it's known as NUA or net unrealized appreciation. There's some preferential tax treatment on employer stock inside of that 401k, and it works like this.

Your cost basis, whatever you paid for that stock over the life of your time at that employer, that's your cost basis. That's going to be taxed when you roll those stocks out to a brokerage account. Instead of an IRA, that cost basis is going to be taxed immediately. That is the only thing that's going to be taxed as soon as you roll those dollars out of the 401k.

There's some important caveats as well. When you do this rollover, everything has to be rolled out of that 401k. You might be taking some of those dollars that are not employer stock over to an IRA and all of the stock out to a brokerage account that's after tax, and again, paying taxes on that cost basis when you do those maneuvers. That's something you want to consider if you have any of that employer stock.

You also could potentially, you said, "Hey, I don't want to roll the whole employer stock out into a brokerage account. Maybe you just want to designate a portion." Well, you can't unless you liquidate it first. You may want to consider liquidating some of that stock if you don't want to roll it all out because it is all or nothing when you elect this NUA opportunity. We have cost basis, taxes, ordinary income.

Then let's say you sell that. If you sell that position, all of that NUA gain, the gain that that stock had while it was inside of the employer plan, that is all taxed at long-term capital gains rates regardless of when you sell it. You could sell it immediately. You could wait five years. The holding period doesn't matter. Typically, the holding period matters when it comes to capital gains.

Typically, you need to hold it for at least a year in order for you to receive that preferential tax treatment at long-term capital gains rates, otherwise, it's short-term capital gains rates, again, taxed at ordinary income tax rate, but it's NUA. Now all that capital appreciation is going to be taxed at those preferential rates regardless of the holding period.

Then you also have this post-distribution gain. You could end up holding on to that position for a while. If you hold on to that position for a while, the holding period does matter for any appreciation that that position has after you actually roll those funds out. That could be short-term capital gains or long-term capital gains, again, depending on the holding period.

Now let's jump in to a specific example so we can get a better idea of how these things are functioning. What we're going to be looking at is just assuming we have $500,000 in our 401k. It's all in employer stock. We just want to really understand this concept from a high level here. We're going to talk about some round numbers and some specific figures along the way. What we're trying to get is the big picture here so that you have an idea of the planning opportunity that you need to take to your advisor or our team for that matter.

Let's say you rolled that $500,000 into an IRA. Well, then everything's going to be taxed at ordinary income tax rates moving forward. We're going to assume, for the sake of this example, that would be 25% between federal, state, local taxes. That's $125,000 in taxes, so your $500,000 IRA is now worth net after tax $375,000. Now let's, instead, say that we elect this NUA opportunity.

If you elect that NUA opportunity, then we have $100,000 in cost basis. We have $400,000 in NUA gain. That $100,000, we're going to again assume we're paying 25%. We're paying $25,000 in our ordinary income taxes. Then on this $400,000, there's a couple different things that we need to understand about capital gains rates and something that's known as net investment income tax, the Medicare surtax. Let's jump into some charts so that we can better understand that.

Here's the thing that many overlook about long-term capital gains rates. As long-term capital gains tax rates, many assume, well, it's going to be taxed at 15% or 20%. Maybe it's 0%. It could be any one of those different things, and it's actually tiered as it fills up those different brackets, and it's going to be stacked on top of your ordinary income. If you're a single filer or married filing jointly, head of household, you have different amounts that you want to keep in mind.

For this example, we're looking at a couple that are 65, and they're in this married filing jointly category. That first $89,250 in capital gains, again, stacked on your ordinary income, there's no tax on those dollars. When it comes to the next pretty much $500,000, that's taxed at 15%. Beyond that, it's going to be taxed at 20%. Many times, people will just stop there, but there's something we need to understand about Medicare taxes.

We have something known as a Medicare surtax that could be applied in addition to those long-term capital gains on our net investment income. We have to understand the thresholds first. There's different thresholds depending on your filing status, 125,000 married filing separately, 200,000 single, 250,000 is the threshold for this example for a couple that are married filing jointly. How's that tax work?

The dollars that are over that amount, we want to calculate our net investment income, we want to calculate or modify adjusted gross income, those two numbers. This $250,000 threshold applies to your modified adjusted gross income. If we have 450,000 in modified adjusted gross income, that is $200,000 over that threshold. Let's say we have $400,000 in net investment income. Well, that 3.8% tax will apply to the lesser of those two numbers, your net investment income or the amount over the threshold. Let's see how it applies to this example.

In this example, we're assuming that they have a $450,000 modified adjusted gross income. We have that $500,000, the $400,000 capital gain. We have the $100,000 in cost basis, that's $500,000. We're assuming they have some deductions here that brought that modified adjusted gross income down to $450,000. We're $200,000 over that threshold, and their net investment income is only the capital gain in this instance. They have $400,000 in capital gains, and that means that the $200,000 is a little less than that $400,000. Their 3.8% Medicare surtax is going to be levied on that $200,000 for a $7,600 tax.

If we add all of those things up, now we have 15% tax, our long-term capital gains tax on the $400,000, that's $60,000. 3.8% on our $200,000, the lesser of those two amounts, that's $7,600, plus our ordinary income. Now it brought our tax bill to $92,600. That's a pretty good improvement over where we were. We were going to walk away with a net $375,000. Now we're walking away with a net of $407,400, but we're going to take this tax savings a little further. I told you, we're going to get to about $100,000, if not a little more than $100,000 in tax savings with another planning opportunity.

That other planning opportunity is known as a charitable remainder trust. This couple said, "Hey, we don't need this lump sum of dollars. We want a little income from it for the rest of our life, but ultimately we'll leave whatever's left over to charity." We just don't really want to give it away today, but we would like some tax deductions today and we would like some income from that asset.

A charitable remainder trust allows us to move dollars or stock into a charitable remainder trust, get income from that asset for the rest of our life or two lifetimes, in this example, and get a tax deduction for remainder interest. That remainder interest is all calculated based on the applicable federal rate. The government gives us these numbers. Those deductions are going to be fairly fixed, but they're largely dependent, other than the applicable federal rate on how much income that you want.

In this example, we're going to take 5% per year of our $500,000 that's in that trust, $25,000 a year. If we were taking 10% per year, the remainder interest would be smaller, the tax deduction would be smaller. In this instance, that tax deduction is $226,000, a little over $226,000, and it's going to be limited to 30% of our AGI because it's stock. If it was cash going into the charitable remainder trust, it would be limited to 50% of our AGI, but we also have a 5-year carry forward, so they can use these dollars over time. They might even want to do a Roth conversion with some of the dollars that they've saved by moving that stock into that charitable remainder trust.

Limited to 30% of the AGI, we're assuming this took their AGI down to $50,000 because now we don't have that $400,000 NUA gain that we're going to incur because we're going to be moving that stock into that charitable remainder trust. We're still going to have that $100,000 cost basis. What do we say? This couple had a $450,000 AGI. We just reduce it by $400,000, so they have $50,000 in AGI, and that $50,000 at 30%, that's $15,000 that they're able to use against their income this year, and again, they get to carry forward those other dollars or find other uses for them, as I said, like a Roth conversion.

I want to give you a way that you can calculate some of these numbers for yourself, though, using a powerful online calculator. In this example, we're using the Michael J. Fox Foundation's calculator that's found on their website. You're going to find this on about every university website. You're going to find this on just about every charitable website that's out there that allows you to run these calculations for yourself to better understand what your deduction would be.

In this instance, we're saying, "Hey, we have two lifetimes. It's going to be distributed over the rest of both of their lifetimes. They're gifting $500,000 into that charitable remainder trust. They're getting fixed payments at 5% for the rest of their lives. The estimated amount that ultimately will go to the Michael J. Fox Foundation, based on a 6% growth rate and their 25-year life expectancy, it's about $774,000, and they get to spend more than what they put in there over time. $625,000 is what's coming back to them over their expected lifetime, and their potential income tax deduction is $176,295 like we saw in that example.

What happened in that example? We took that whole $500,000 stock, rolled it into the charitable remainder trust, so we had no tax on that $400,000 capital gain, and they even put those dollars in the trust. One of the reasons a lot of people choose to do this is they don't want to incur the tax on a concentrated stock position, but they want to re-diversify it and reduce some of the risk level. We can roll those dollars in. It can be liquidated once it's inside of that charitable remainder trust, and we still don't have to worry about incurring a big tax when we do that.

We also have a cost basis of $100,000 that's getting taxed. We're now assuming at 15% between federal, state, and local taxes, again, got that big tax deduction. Even though we're not using a whole lot of it, we're still in a very low tax bracket. It's going to save us some money on taxes. Let's assume $15,000 in taxes. Now we netted $485,000. What's the big picture here? We took $500,000 account that would have been worth maybe $375,000, just doing NUA. Now it's worth $407,400, and now we use the NUA and the charitable remainder trust, we have $485,000 plus carry forward deductions on those assets.

Another thing that I think it's important for you to remind yourself of when you're doing NUA and something a lot of advisors seem to overlook, that is there is no step up in basis upon death on the NUA gain. Keep that in mind. A lot of people overlook that. This is all dependent on what your goals are. Are your goals to leave a legacy asset behind to your heirs? If that's the case, maybe you're electing this opportunity here to just do NUA, and you could take whatever's left over, that $407,000, you could buy it right back into that stock, and then all the capital appreciation moving forward, it's all going to be stepped up in basis upon death.

There's a lot of different planning opportunities that you could do to elevate your legacy here. Maybe you're more charitably inclined, and you're a little bit more tax-conscious, you want to go this way. It's all dependent on your own unique situation. What I'm encouraging you to do is if you have employer stock inside of your 401k, give our team a call and have us run a free tax analysis for you to show you what all of those tax planning opportunities are for you before you roll that 401k into an IRA or you elect NUA for that matter. Just give us a call for a free personal financial review with a financial planner on our team. We meet with people across the entire country, and we look forward to meeting with you.

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