Employer stock in a plan and net unrealized appreciation

How it works

The rule applies when the entire plan balance is distributed within one year after a triggering event, such as leaving the job, reaching 59 and a half, disability, or death. The employer shares are moved into a taxable brokerage account rather than rolled to an IRA, while the rest of the plan can be rolled over. In the year of the distribution the worker pays ordinary income tax on the plan's cost basis in the shares, the amount the plan paid for them, and a 10 percent addition on that basis if under 55 at separation. The difference between that basis and the market value on the day of distribution is the net unrealized appreciation, which is taxed as long term capital gain only when the shares are sold, no matter how soon.

What it gives

Years of growth in company stock can be taxed at the long term rate rather than as ordinary income.

The shares can be sold right away and the appreciation still gets the long term rate.

The rest of the plan can still be rolled to an IRA in the same transaction.

What it costs, or where the catch is

Tax on the cost basis is due in the year of the distribution, in cash.

Rolling the employer shares into an IRA, even by accident, ends the chance for good.

It helps only when the basis is low relative to the value, and holding a large block of one company's stock carries its own risk.

A worked example

Hugo retires at 62 with $400,000 in his 401(k), of which $150,000 is company stock the plan bought for $30,000. He has the shares sent to a brokerage account and rolls the other $250,000 to an IRA. This year he pays ordinary tax on the $30,000 basis, about $6,600 at 22 percent. The $120,000 of appreciation, which is $150,000 minus $30,000, is taxed at 15 percent when he sells, which is $18,000, instead of the $26,400 ordinary tax it would have drawn coming out of an IRA.

Where it goes wrong

The common miss is a departing worker who rolls everything to an IRA, as the paperwork invites, and loses the treatment forever.

Who confirms it for you

For your own numbers, a CPA or enrolled agent. This page explains how the rule works for people in general; it does not know your situation and does not tell you what to do.

The official source

IRS Publication 575, Pension and Annuity Income. Every figure that changes by year comes from the site's rules table, which the watcher checks against the official page on a schedule; where a figure is not yet verified, this page says so instead of printing a number.