I’VE DEVELOPED a series of what I call “Geico talks,” named after the ubiquitous insurance company commercials. They’re 15-minute talks that, I joke, are aimed at boosting financial knowledge by 15% or more.
The talks are for friends and acquaintances who work at the same company as me or at companies with similar employee benefits. These firms typically have great retirement plans and many employees own company stock. I figured the topics I’d researched for my own finances would help these folks. I also suspected that some friends were making the same mistakes I’d made. With that in mind, I came up with three Geico talks:
1. After-tax 401(k) contributions. Only a minority of 401(k) plans allow so-called mega-backdoor Roth conversions, but it’s worth checking to see whether your plan does. What’s involved? It starts with making after-tax contributions to your employer’s 401(k). These contributions are over and above the usual tax-deductible or Roth 401(k) contribution limit, which in 2020 is $19,500 for those under age 50.
The after-tax contributions can sometimes be immediately converted to the company’s Roth 401(k), where the money grows tax-free thereafter. Alternatively, the after-tax dollars can be transferred to a Roth IRA, either while you’re still employed or when you leave the company. If the money ends up in a Roth IRA, either immediately or when you leave your employer, it also escapes the rules for required minimum distributions that apply starting at age 72.
My employer’s 401(k) plan allows both after-tax contributions and the ability to convert that money over to the Roth 401(k) option. Ditto for the employers of some friends. Be warned: If you convert to a Roth and the after-tax dollars have enjoyed some investment gains, the conversion will trigger a tax bill, though it’ll typically be modest.
2. Company stock. Many employers—especially technology companies—offer stock-based compensation. This bolsters employees’ commitment and allows them to participate in the company’s growth. Over time, workers can build up sizable holdings of company stock. If the stock does well, as has been the case for some tech companies, it often becomes a significant portion of the individual’s total stock market holdings. The percentage looks even higher if unvested shares are added to the mix.
My employer makes stock grants as part of an employee’s compensation package, offers a discounted employee stock purchase plan and makes its publicly traded shares available within the 401(k). Most employees accumulate a sizable number of shares each year. We’ve been lucky: The stock has outperformed the broad U.S. stock market by a large margin over the past decade. Result? Several old-timers have ended up with more than half of their stock portfolio in our employer’s shares.
Our employer is viewed as a stable, large-cap company with a proven track record and a promising future. Still, overexposure to a single stock poses significant risk—so-called unsystematic risk. Unfortunately, optimism and recency bias can blind employees to the magnitude of this risk.
Even those aware of the financial danger involved are often hesitant to do anything about it. The potential tax bill discourages them from selling. Still, we shouldn’t let taxes drive such a crucial investment decision. Selling pricier lots, harvesting tax losses, gifting shares and other strategies can ease a lot of the tax pain.
3. Net unrealized appreciation. Tax-deductible contributions to a 401(k) grow tax-deferred. But when the money is withdrawn, the entire sum is taxed at the ordinary income rate, even when the growth is due to long-term capital gains. Such capital gains are usually taxed at a lower rate, but only if they occur in a regular taxable account.
Wouldn’t it be nice to get the best of both worlds, enjoying both tax deferral and the lower capital gains tax rate? The net unrealized appreciation, or NUA, strategy can achieve just that—if you hold company stock in a 401(k).
How does this work? An employee buys company shares in the 401(k). The plan keeps track of the stock’s cost basis—the amount the employee paid for the shares. If the shares appreciate substantially by the time the employee retires or leaves, the employee will likely want to request that the shares be distributed to a taxable account, while the rest of the 401(k) gets rolled over to an IRA.
The employee immediately owes ordinary income tax on the company stock, but only on the cost basis. Meanwhile, the unrealized gain on the stock would be taxed at the lower capital gains tax rate when the shares are sold. If the shares appreciate further and are sold after a year, that extra gain also gets taxed at the favorable long-term capital gains rate.
The NUA is often advantageous, but it isn’t always the best choice. In particular, the immediate income tax bill can be steep if the cost basis on the shares is high—in which case you might want to skip the NUA strategy and instead defer the tax bill by rolling everything into an IRA.
A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include Got Gold, Risky Option and Thanks for Nothing. Self-taught in investments, Sanjib passed the Series 65 licensing exam as a non-industry candidate. He’s passionate about raising financial literacy and enjoys helping others with their finances.