Many people, including some advisors, 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 planne. We set up a nicely balanced portfolio of mostly low cost index 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.

"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 ordinary 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?

You bet. Suppose you had worked at Dell Computer over the last ten years. With a stock that has appreciated at nearly a 40 percent compound rate over the period, company shares added to a 401k 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 separate 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.

     • You have to get company stock in your retirement savings plan,          and it has to appreciate at a brisk clip. While there are over          6,000 publicly traded companies in the U.S., some don't offer 401(k)          plans and about 1,000 depreciated over the last 10 years. Many others          appreciated modestly so their net unrealized appreciation is small.

     • Many workers, regardless of tax bracket, regularly sell their          employer shares as a prudent diversification move and replace them          with mutual fund shares. As a consequence, they never accumulate a          large holding of employer stock.

That said, there are thousands of long term workers at oil companies (think Exxon, Chevron), some retailers (think Best Buy), and many technology companies who should seek tax advice before they dispose of their company shares.  

On the web:

Don't convert it willy nilly--- see an accountant, Thursday, December 22, 2005

Revisiting Net Unrealized Appreciation: A Tax Wise Strategy That May Realize More Benefits Than Ever, Journal of Financial Planning, February 2004