Monday, December 31, 2007

Another big reason why you should have Stock in a 401(k)

For the Tax advantage!

If you thought, like I did, that everything in your 401k from bonds to equities to mutual funds would be exposed to the same awful ordinary income tax rate at withdrawal – check out this seldom discussed or written about 401(k) maneuver that could save a lot in taxes.

Retirees who withdraw their employer's stock, rather than rolling the shares into an Individual Retirement Account will enjoy a tax break.

Upon withdrawal, the retiree will pay taxes on the average cost of the shares when they were bought in the plan.
When shares are sold, the gain (the difference between the current value and cost in the plan) is taxed at long-term capital gains rates.

Given the difference between the top ordinary income tax rate (35 percent) and long-term capital gains rate (15 percent), this tax break can be significant.

For an example, let’s assume you own 1,000 shares in your 401(k) plan that are worth $100 a share, or $100,000, and that these shares were acquired in the plan at an average cost of $20 per share. Roll the shares to an IRA and pay no tax now. Later on, you can take all 1,000 shares out of the IRA, and if you're in the top 35 percent income tax bracket, you'll pay $35,000 in ordinary income taxes on the entire $100,000.

Instead, Do Not Roll the shares into an IRA. Take them out of the plan now and pay ordinary income taxes on the cost of $20,000. In a 35 percent tax bracket, that's $7,000 in taxes now. Later, sell the shares and pay capital gains taxes at 15 percent on $80,000. This works out to be another $12,000 in taxes. Total taxes paid: $19,000 versus $35,000 in taxes if rolling over the shares to an IRA and the shares out later.

One other key point to consider is that If you never sell and left the assets to your heirs, the cost basis on the shares will be stepped up to their value on the date of your death. Your heirs could then sell the shares and never be taxed on any gains!

This gives me one more reason to hang on to my company stock. I had considered selling the stock simply because it has grown to over 10% of my portfolio. I have been struggling with that since its fundamentals are still excellent and its a great stock to hold in recession or bear markets.

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