Retirement Tricks

By Daniel Kadlec

A once obscure tax strategy that makes the most of your 401(k) dollars is going mainstream. The move keys on an IRS provision that lets you take possession of company stock in your 401(k) plan instead of rolling it into a traditional IRA when you change jobs or retire. The resulting savings can be staggering, and thanks to the crush of corporations that juice employee retirement accounts with their own shares these days, more people than ever stand to benefit.

The provision is not new. But word has spread slowly, largely because companies avoid dispensing anything that approaches individual tax advice and there's nothing in it for the IRA industry. But financial planners I've spoken with endorse the strategy with such vigor that you have to worry about hype. This isn't a no-brainer. And the pitfalls include the risk that you'll wind up overly concentrated in one stock. You also have to pay a tax up front.

It's a winner for fat-cat execs (as usual) who are sitting on highly appreciated employer stock in their 401(k)s and don't need the money to live on. But the run-up in stock prices over the past five years means a lot of working stiffs will measure up too. If during this time you've contributed diligently to a plan--especially if your employer matches all or part of your contribution--you could easily have $750,000 or more at retirement. It's the appreciation in the company shares that matters. "We see it all the time," says Joanne Carter, IRA product manager at PaineWebber. "That's why dealing with company stock is a big issue."

The standard advice is to roll all 401(k) assets into a traditional IRA, thus avoiding any taxable distribution while gaining total control over your nest egg. In the long run, though, all such IRA money gets taxed as ordinary income, at rates up to 39.6%. By stripping out the employer shares and placing them in a taxable account, you change the math dramatically. There's an up-front tax hit: the "cost basis" of the employer shares--the amount the plan paid--gets taxed as ordinary income. But the increase in value isn't taxed until you sell the shares and then at the lower capital-gains rate of 20% for long-held assets.

Say you have $500,000 in company stock, with a cost basis of $100,000. If you are in the 31% tax bracket and take possession of the stock, you will immediately owe $31,000. But the eventual tax on that $400,000 will be just $80,000 for a total tax bite of $111,000. In an IRA rollover the total bite would be $155,000. And by taking possession, you can later pass the stock on to heirs at a stepped-up basis. Your heirs will pay capital-gains tax on the difference between the cost basis and the market value at the time you took the shares. But subsequent growth in your lifetime will not be taxed.

These are powerful inducements that must be weighed against individual needs. The immediate tax bite may not be worth it if you have to use 401(k) assets to pay the bill. And the math doesn't work if your company's stock has been a dud. The diversification issue looms large as well. Rolling into an IRA allows you to sell the stock without triggering a tax liability and then buy mutual funds to reduce risk.

Ask your company for the cost basis of the stock in your plan. If the market value is less than double the cost basis, you've got nothing to consider. But that's a fairly low bar, and above it lie enticing possibilities.

See time.com/personal for more on 401(k) strategy. Dan appears on CNNfn regularly. His e-mail address is [email protected]