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How to handle company stock in your 401(k) at retirement


Owning stock in the company you work for is a strange investment.

You can feel like you should own it to show loyalty, or that you have insider knowledge on the company so can time when to get in or out. Or it can be gifted to you, or given your stature in the company, you are mandated to hold a certain portion of your investments in this stock. Many employees/investors don’t look at their company stock the same way they do as their other investments – it’s got a weird emotional attachment that goes along with it.

For those readers who are not quite at retirement yet and are building up their savings – it’s best not to hold too much (or any) stock of the company who is also paying you. The rule of thumb is no more than 10% of your portfolio in one stock, but I would bring this down to 5% if it’s also the same company that is providing you an income. While you may think you have the inside scoop and can make some smart decisions, many people have been burned by this approach and been left with nothing (Google “Enron” to see more of what I mean).

But for those readers who have substantial positions in their company stock inside their 401(k) – either through choice or otherwise – there are ways to effectively to de-risk your situation and make your net worth less beholden to one company.

 

Dollar-Cost Average Out

This method is the reverse of what you’ve been doing your whole career. Every month, you’ve been purchasing the same funds regardless of what the market has been doing. Called an “automatic investing plan”, it’s built on the premise of “dollar cost averaging” where you invest based on time segments versus prices in the market. It removes emotion from the investing process and makes sure that you invest your money while taking advantage of different prices in the stock market.

Dollar-Cost-Averaging-Out (DCAO) of a position is just like Dollar-Cost-Averaging-In (DCAI). In the DCAO, you determine the time period you would like to divest of the position – either the whole or partial amount – and then at set time periods of the next 12-24 months, you then sell a set percentage and put the proceeds into a diversified portfolio. The timeframe can be determined on the dollar value of the position, the aggressiveness as to which you wish to diversify, and sometimes the company’s constraints on you remaining invested. Whatever the timetable, DCAO is an unemotional strategy for reducing your risk in a single position.

 

Net Unrealized Appreciation (NUA)

A strategy that can be used for large positions that have grown significantly since they have been purchased, thus having a low basis, is NUA

In a scenario, 100 shares of stock are purchased at $10/share. Over time, they have appreciated to being worth $100/share. When they get taken out of the 401(k), the whole amount is taxed at ordinary income rates.

But what if that could be avoided and a capital gains rate was used on the growth of the stock position? That’s what NUA is for, and is used for greatly appreciated stock positions in tax-deferred accounts.

When you retire, instead of rolling over the entire 401(k) balance to an IRA, the company stock is moved to a taxable account using the NUA strategy. The distribution triggers taxes on the basis of the stock, and capital gains taxes on the stock are only recognized when you start selling the position. In order to be eligible for long-term capital gains, you’ll have to hold the position longer than 12 months, so being able to whether the stock price fluctuations should be a consideration when using this strategy.

 

But my 401(k) holds other funds other than my company stock?

This question is true for almost everyone using this strategy and some upfront planning has to done before NUA is an appropriate strategy.

-       Wait until you are over 59.5 and can move funds to an IRA without penalty. Additionally, you can separate from employment and not be subject to age rules.

-       Elect to do a partial 401(k) rollover, and roll over everything but the company stock to an IRA. This leaves just your company stock in the 401(k).

-       As the NUA process states that all the holdings in a 401(k) must be transferred to the taxable account, this doesn’t pose a problem as nothing else but the stock left in the account.

-       Initiate the process, pay the immediate income taxes on the stock’s basis, and hold the stock in the taxable account for longer than 12 months to get preferential long-term gains tax treatment. At that point, you can start to sell off the stock and diversify at a pace that you are comfortable with.

 

While the best scenario is that a 401(k) is fully diversified and doesn’t contain any single stock positions, there are ways to manage these scenarios should they be apparent.