If you are a regular reader of this blog, you know there are many ways to save for retirement. Some retirement plans are more unique than others; an employee stock ownership plan (ESOP) is an example of a less common piece of one’s retirement and has quirks that are critical to understand as a participant. There are two significant pieces that a participant must incorporate in their plan. Otherwise, they could be inadvertently derailing their retirement. These two risks are tax risk and concentration risk.
If you aren’t familiar with the term, ESOP, or employee stock ownership plan, you likely don’t participate in one. Not every company offers these plans. In fact, according to ESOP.org, in 2018 there were an estimated 6,500 in existence. Within those 6,500 ESOP plans, there are approximately 14 million people that must be aware of the impact these plans have on their retirement and the tax consequences.
The history behind these retirement plans is one of the big guy looking out for the low man on the totem pole and a result of out of the box thinking. In the late 1950s, a newspaper company was owned by several people who wanted to retire, but the owners were hesitant to sell the company, for fear of their employees’ future. As a creative solution to their retirement problem, they launched the first employee stock ownership plan to transfer ownership of the company to their loyal employees.
Historically employee stock option plans were a way for companies to grant their employees stock, allowing the employees to feel a sense of ownership in the company and the employer to exit the company on their own terms. The plans were designed as a retirement savings plan. Therefore the employee’s shares of stock are to be held in retirement accounts, similar to 401(k).
What did Uncle Sam say about that?
Owning stock in a retirement account was not the most tax efficient situation for the employees, because they were forced into paying potentially higher income tax rates versus potentially lower capital gains rates if the stock had been held in a non-retirement account. Thus, the IRS caught up and introduced the ‘net unrealized appreciation’ (NUA) treatment to add a solution to one of our risks, taxation.
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How NUA works is a little tricky, and there are specific rules that must be followed in order to be eligible for the favorable tax treatment. The NUA treatment first looks at your cost basis; this will be taxable at your ordinary income rate. Then the difference between what the stock is worth at the time of the distribution and your cost basis is treated as a gain, thus taxed at your capital gains rate. Remember, if you are married filing jointly and your tax bracket is less than 15%, your capital gains rate is zero.
NUA becomes more critical the more highly appreciated the stock is that you are distributing. As the difference between the cost basis of your shares of employer stock and the current market value of those shares increases, your potential tax savings increases.
For example, assume your cost basis is $10,000, and the value has increased to $80,000. If you are in the 24% bracket (MFJ), your tax impact would be $10,500 on the $70,000 gain (excluding the income tax on the cost basis.) However, if you had not utilized NUA treatment, your tax impact would be $16,800, as it would be taxed at standard income tax rates.
There are two key terms that must be satisfied in to qualify for the favorable NUA treatment. The employer stock must be distributed in a lump sum and in-kind. Once you have triggering event, such as retirement, you may transfer your employer stock in your employer-sponsored retirement plan, in-kind as a lump sum. This will allow you to realize the gains on the stock to be taxed at long-term capital gains rates when the stock is sold. The cost basis will be taxed immediately as ordinary income.
Timing is everything!
During this transfer, you must be very careful not to sell too early, because if the shares are sold and repurchased, that will make you ineligible for the NUA treatment. The stock must be transferred in-kind. The term lump sum refers to the entire retirement account; in other words, you must transfer all assets, stock, and any other holdings you own within your employer-sponsored retirement account. This transfer of all assets must be completed within one tax year. The timing of this transfer is only allowable in four very specific instances, death, disability, separation from service (i.e., retirement), or at 59 ½ years old.
Throughout your accumulation of your ESOP, one must also consider the impact of concentration. Concentration simply meaning the all eggs in one basket approach that is inherently part of an ESOP. The concentration risk is relevant as you accumulate more and more shares of your employer stock and increases as you get closer to retirement. Not only is your paycheck tied to your employer’s success but potentially a large portion of your retirement. The more of one area of the market or one individual stock you hold, the more susceptible you are to increased swings up and down, based on how that holding performs.
To counteract this concentration, you may begin saving outside of your ESOP. Depending on your income level, you may start diversifying your retirement savings in a Roth IRA or a Traditional IRA. These additional accounts will allow the flexibility to select investments that in conjunction with your ESOP, will align with your overall risk tolerance. Diversification across all of your accounts will allow you to combat the concentration risk inherent with ESOPs.
I’m ready to retire!
When an employee retires, they most commonly rollover their employer-sponsored plan to an IRA. However, ESOPs are not the run of the mill employer-sponsored plan. There are essentially two routes, either roll your ESOP into an IRA or plan to take advantage of NUA.
- Route 1, rolling into an IRA, tends to the be most effective for employees in higher tax brackets holding employer stock that has not appreciated significantly. Thus, the potential savings on how the appreciation will be taxed will be minimal.
- Route 2, taking advantage of NUA tends to be the most effective for employees in lower to mid-level tax brackets with highly appreciated stock. Another consideration is how the tax bill will be paid. By taking advantage of the NUA treatment, taxes will be due. In the transition to retirement, you must also ensure there will be sufficient funds to pay the resulting tax bill.
As discussed in the ‘Plan to Reduce Taxes in Retirement’ blog, tax planning is a critical piece to your overall retirement plan. Weighing which ESOP approach is right for you, either taking the distribution as a lump sum, in-kind transfer to benefit from NUA or rolling over your ESOP to an IRA is an analysis that must be evaluated considering your current and projected tax situation and the performance of the stock itself. There is not a one size fits all answer.