401k and Employee Ownership: Company Stock
Many companies have chosen to provide employees with an ownership interest by offering company stock through their 401k plan. The company can accomplish this in two ways:
1. Your employer can combine an ESOP with a 401k, creating a KSOP. In a KSOP, the company matches employee 401k contributions to the plan with a contribution of company stock. As with a standard 401k plan, employee contributions are invested in various fund options offered by the plan.
Some companies match employee contributions according to a fixed formula with contributions in company stock, but do not set up a formal ESOP to hold the company contributions. Other companies make their profit sharing matching contributions in company stock. In some cases, the company might place restrictions on how the stock vests or can be sold if it is not publicly traded.
2. Your employer can permit you to purchase company stock with your plan assets, essentially making company stock one of the choices in your asset allocation plan.
If company stock is offered through your 401k, your company must provide you with additional
financial information. In the case of a publicly traded company, this usually takes the form of an annual report and, in some cases, quarterly updates. This financial disclosure is intended to empower you, as an investor, to make an informed investment decision about your overall retirement asset allocation model.
One caveat: Purchasing company stock through your 401k or receiving it from your employer's
match is not like drawing from a bottomless well. Some companies limit the amount of company stock that you can own in your account. Once you have a percentage of your assets in company stock, for example 25 percent, you may not be allowed to accumulate additional shares.
The Benefits of Company Stock in a 401k
So how good is the company stock option in your 401k? The payoffs of ownership are potentially substantial, but involve risk. Indeed, when Microsoft Corporation went public and Cain Chemical, Inc. was acquired, the value of the company stock held in both firms' profit sharing plans soared-and catapulted to wealth hourly employees and executives alike. Ownership in your company's stock can provide this wealth to you in two ways:
1. When you receive profits distributed in the form of dividends
2. When your company has increased in value and your company stock value goes up
In essence, when the company is well run and profitable, you are included in that success.
Thanks to 401k plan regulations, investing 401k assets in company stock has additional benefits. Federal rules prohibit investment managers from taking a commission from the sale or purchase of company stock in a defined contribution plan, when the transaction is made directly with the company. Also, there are no investment management fees for 401k amounts invested in company stock. Reducing fees in these two ways significantly reduces costs, and can result in better long-term net returns for your 401k portfolio.
Another major benefit of owning company stock is the tax regulation known as the net unrealized
appreciation exception (NUA), which provides a special tax advantage. This tax treatment provides that when you take a lump sum distribution in company stock from your 401k plan, you initially pay regular income taxes on only the initial cost of the shares to the plan (called the cost basis) rather than on their current value. You do not pay tax on the value of the appreciation until you sell the stock, at which time you pay tax at the capital gains tax rate, even if you sell the stock one day after you receive it from the plan.
This can be a substantial tax break if the current capital gains tax rate is considerably lower than the income tax rate you pay on other 401k distributions, which are taxed at ordinary income tax rates.
However, taking a lump sum distribution in order to take advantage of NUA is not always the best approach. Keeping your accumulation tax-deferred may be more appropriate, depending on the situation. You should carefully evaluate this choice before making a decision. You may want to consult with a financial planner or tax advisor to determine what makes the most sense for you. If you decide that you want to take advantage of this tax benefit, your plan sponsor will need to record and track the cost basis of all stock contributed to your account. Most companies have excellent recordkeeping support systems to help you when it is time to take a distribution from your 401k plan. Be advised that if you roll your company stock into an IRA, or you roll your stock distribution over into another 401k plan, you will not be able to take advantage of this special tax treatment.
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