Tax Bomb: Employer Stock Inside $4.2M 401(k) Could Cost Dearly

A 61-year-old separating from service has a $4.2 million 401(k) with $880,000 in employer stock. The stock has a $185,000 cost basis and $695,000 of embedded appreciation. Rolling the entire balance to an IRA would convert the $695,000 of long-term capital gains into ordinary income taxed at the marginal rate during withdrawals. Inside a 401(k), distributions are treated as ordinary income. Net Unrealized Appreciation rules allow the employer stock to be separated from the rest of the plan. The cost basis portion is taxed as ordinary income in the year of distribution, while the embedded appreciation portion can be taxed at long-term capital gains rates when the shares are sold, potentially reducing lifetime federal taxes.

"Inside a 401(k), every dollar comes out as ordinary income. At her likely retirement marginal bracket, that means federal rates of 24% or 32% on each withdrawal. Run the embedded appreciation through that filter and the IRS collects $180,000 to $220,000 over the retirement horizon."

"Net Unrealized Appreciation, explained in IRS Publication 575, lets her separate the employer stock from the rest of the plan. The $185,000 cost basis is taxed as ordinary income in the year of distribution, costing roughly $59,000 at a 32% marginal rate. The $695,000 of appreciation is taxed at long-term capital gains rates of 15% to 20% when shares are sold, with no holding period required for the original NUA gain."

"Her default instinct is to roll the entire balance into an IRA. That single decision would permanently convert $695,000 of long-term capital gains into ordinary income, payable at her marginal rate as she draws the money down."

"This scenario surfaces repeatedly in retirement forums, where listeners with concentrated employer stock are routinely told to roll it all to an IRA. That advice is fine for the bond fund and the target-date equity sleeve. It is wrong for employer stock, experts say."

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