Highly paid business executives frequently receive some of their compensation in the form of their company’s stock, and by the time they retire it can be worth many times what it was when it was received.
It’s often put in the executive’s retirement account, along with other funds the executive and employer contribute over the years. For the most part, funds taken out of a tax-qualified retirement account are considered income and taxed at income tax rates. This includes the original value of the stock (or cost basis) and the profit on the stock (or net unrealized appreciation.)
If the stock has increased in value while it was in the retirement account, withdrawing it can result in a hefty income tax bill.
This particular client, Lampe says, had worked for the same oil company for most of his working life and had $1.3 million in highly appreciated, publicly traded company stock in his employer-sponsored retirement account when he was ready to retire in his late 60s about eight years ago.
If the money for the stock had been withdrawn at his retirement and certain strategies had not been used, the entire amount would have been taxed at regular income tax rates, which generally range between 25% and 37%, depending on the client’s level of income. However, Lampe suggested the client use an IRS-allowed strategy that enabled him to pay the much lower capital gains tax rate on the net unrealized appreciation, meaning the amount the stock had grown in value while it was in the retirement account. He still would have to pay income tax rates on the remainder of the nonstock retirement money, as anyone would when withdrawing money from a tax-qualified retirement account, as well as on the original value of the stocks.
However, simply by withdrawing the net unrealized appreciation in a lump sum with the rest of the retirement account, the client was able to put the money in a traditional brokerage account, set up a plan to withdraw the funds over a period of years, and pay the lower capital gains rate, Lampe says. In effect, the appreciation is given the same tax treatment that would have been applied to the stock had it been held outside of a retirement account. Capital gains tax rates are 15% or 20%, depending on the income level.
Lampe, who has a bachelor’s degree in personal financial planning, deals with a sophisticated clientele and says he is always looking for ways to do efficient tax planning. He says he learned about this tax-advantaged method of handling appreciated assets through talks with colleagues. It is allowed under a provision Lampe describes as “one little paragraph in the IRS code.”
When large, publicly traded businesses reward employees with company stock through a profit-sharing or retirement plan, it is often done to make employees part owners. In order to take advantage of this tax rule, the employee must experience a “separation event” from the employer, which is usually retirement. He or she must also take the entire amount of the retirement account in one lump sum, and not leave any with the former employer. Once the owner starts taking withdrawals from the account, the money can be reinvested or used as the owner pleases.
The decision account holders have to make at that point is when they want to pay the taxes. Obviously, the more money that is withdrawn to use, the more capital gains tax will be due. If the stock is sold, it will be subject to the lower capital gains rate, but the bill will be due immediately. If it is rolled over to a brokerage account and withdrawn over a period of years, the capital gains rate taxes will be due over a period of years, Lampe says.
“For this client, the most advantageous choice was to put the money into a brokerage account, because this allowed him and his wife to get the most out of their money while avoiding raising their income and paying a higher income tax rate on other money,” Lampe says.
In this case, the stock was worth approximately $1.3 million when the client retired, which he and his wife did not need immediately. The amount included $600,000 in net unrealized appreciation. If the total value of the stock were taxed at income tax rates, the tax bill could have come to $534,000. But if the net unrealized appreciation portion was taxed at capital gains rates, it would come to $224,000, saving the client more than $300,000, Lampe explains.
Until it is needed by the client, the money can be managed by the financial advisor. For his client, Lampe says he set up a brokerage account, and the couple withdrew $50,000 to $75,000 a year to supplement their other income sources. The drawdown has to be coordinated with other income so that taxes on those sources are not escalated, Lampe says. This client is in the eighth year of a 10-year drawdown strategy.
“Having a ‘no stone unturned’ mentality when it comes to the tax code allows an advisor to find not just a solution, but the right solution for the client’s goals,” Lampe says. “We preach diversification, but sometimes clients end up with a large investment in company stock, and we have to deal with that to help them, as in this particular case.”