Pros and Cons of Special Tax Treatment for Employer Stock

In the last two posts I discussed special tax treatment for employer stock distributed to you out of your company’s retirement plan—sometimes called NUA treatment. But maybe it’s not so special after all. As pointed out in yesterday’s post, rolling over the stock into an IRA precludes NUA treatment, and vice versa. So which will it be? Door Number One or Door Number Two? Pay a lower capital gain tax, or get (likely) greater tax deferral with an IRA rollover. This is the same broad category of question that arises in other guises. See, for example, March 23’s post.

The issue is made extra difficult because you face two uncertainties, rather than just one. Usually, the issue of short-term low tax vs. long-term tax deferral turns on projecting when you will have to take distributions from your IRA; which is governed by a combination of the required minimum distribution rules, and your need to meet your living expenses. But with NUA treatment another uncertainty is added to the mix. When will you want to sell the employer stock you received, not because you need the money, but because it no longer fits into your investment planning? When you worked for the company, you were all, like, “Rah, rah, rah. This stock is going up, up, up” That was then. Now you’re like, “Whoa! Too many eggs in one basket. I’d better diversify this puppy.” Think Enron.

So for reasons of diversification, one would expect (one would certainly hope) that you’ll be selling a good chunk of that stock soon. So where should that sale occur? Inside the tax-sheltered environment of your IRA, knowing you’ll eventually pay a higher tax as the proceeds are distributed? Or outside the IRA, where you pay a smaller capital gains tax upon sale, but likely earlier than you otherwise would have, and without the further advantage of investing the sale proceeds in a tax-exempt environment? And even if you don’t plan to sell a bunch of stock for diversification purposes, you still might have to sell a chunk of it to raise the cash to pay the tax on the part of the stock that’s not Net Unrealized Appreciation, i.e., the trustee’s cost basis.

It’s not easy. My rule of thumb is (and rules of thumb are always wrong), when in doubt, opt for the long-term benefits of the IRA, and forego the siren lure of the lower capital gain tax rate. Or just opt for NUA treatment on a small portion of the stock—the portion that you’re not going to shortly diversify—say, 5% of it—and roll over the balance into your IRA. But that’s just me.