Publication: Investor's Notebook
THE NET UNREALIZED APPRECIATION DECISION, UP CLOSE | |
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Investor's Insight - Wednesday, January 18, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
Comment The Post Below...
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THE NET UNREALIZED APPRECIATION DECISION, UP CLOSE
by Scott Burns
Many people, including some advisers, have little or no
knowledge of the "net unrealized appreciation" option for
the use of company stock in tax-deferred savings plans.
In fact, it's an important decision. Witness this story
from reader S.A. in Houston:
"You mentioned in your column that under no circumstances
should one with substantial company stock in a 401(k)
convert it 'willy-nilly' into mutual funds.
"In my own case, about four years ago my 401(k) held about
$800,000 in Chevron stock and only $200,000 in various
mutual funds. Desiring to lower my overall investment risk
as I approached retirement, I began selling the stock and
converting it to mutual funds. I did this over a period of
about six months on the advice of a financial planner. We
set up a nicely balanced portfolio of mostly low-cost in-
dex funds, about 60 percent stocks and 40 percent bonds.
No money was removed from the 401(k), and its total value
has grown substantially since 2002.
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"Now I'm worried.
"My approach seemed justified and systematic at the time
(not willy-nilly). But I did not receive any advice on
unrealized appreciation. Was this a mistake from a tax-
planning perspective? I'm considering retirement in 2006."
Sadly, while S.A.'s portfolio has done well, his adviser
should have told him about his opportunity to realize much
of the $800,000 as capital gain income rather than ordinary
income.
What happened here is a collision between a little-known
wrinkle in our tax laws and rational portfolio management.
Workers who receive employer stock shares in their 401(k)
plans have an interesting choice -- IF the shares have
appreciated substantially.
They can sell those shares and take the money out as or-
dinary income through their qualified plan.
Or they can take the net unrealized appreciation option.
This allows them to put the shares in a separate account
when they leave their employer, and pay ordinary income
taxes on the cost basis of their employer shares and lower
capital gains taxes on the increase in value. They may
also hold the shares until their death, which would allow
the unrealized gain to escape taxation altogether.
Can this be a good deal?
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You bet. Suppose you had worked at Dell Computer over the
last 10 years. With a stock that has appreciated at nearly
a 40 percent compound rate over the period, company shares
added to a 401(k) account 10 years ago have a cost basis
of about 3 cents on the dollar. The same goes for workers
at Whole Foods, a stock that has appreciated at about the
same rate as Dell.
As a consequence, a worker leaving either company can sep-
arate the shares, pay ordinary income taxes on the original
cost basis, and pay capital gains taxes at 15 percent on
the remainder. If you're in the 33 percent tax bracket for
ordinary income, the difference can be substantial.
Unfortunately, few are in this club.
Here are the main reasons most workers don't need to be
concerned about net unrealized appreciation:
Most workers are in the 15 percent tax bracket. So the
wrinkle won't save them taxes. You have to have a taxable
income (after exemptions and deductions) over $30,650 to
pay more than 15 percent as a single person or $61,300 to
pay more than 15 percent filing as a joint return.
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END OF INVESTOR'S INSIGHT
Copyright 2006 by PENN LLC. All rights reserved.
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