A client was retiring from a public company. While reviewing the client's 401(k), we discovered that there was a sizable position in the company stock within the 401(k), accumulated over the years from the employer matching contribution. We asked the client to confer with the human resources department at the company to determine the cost basis of the stock in the account. This was to take advantage of the favorable tax treatment of this low-basis stock by the IRS, known as net unrealized appreciation (NUA). Using NUA, a plan participant can take a lump-sum distribution of company stock at retirement, and pay ordinary income tax on the cost basis, not the market value, of the stock. In many cases, this cost basis is a fraction of the market value. After the distribution from the plan, the stock can then be sold, regardless of holding period, and the gain is taxed as long-term capital gain. Contrast this to the treatment if the stock was rolled over to an IRA, where all future distributions are taxed at ordinary income tax rates. Fortunately for this client, the cost basis of this stock was extremely low. Therefore, we were able to take advantage of NUA and were able to save this client tens of thousands of dollars in income taxes.
Income tax planning in retirement
For most of us, it is difficult to manage our income taxes during our working lives. We have W-2 income, interest and dividends and maybe self-employment income. However, if we have planned ahead, we can manage our income in retirement in a manner that will significantly lower our income taxes. Take, for example, one of our long-term clients, a retired executive living in Florida. Despite a very comfortable lifestyle and required minimum distributions from his IRA, we have been able to keep his federal income tax effective rate in the single-digit range on an annual basis. This is done by the use of tax-free investments, careful selling of appreciated assets and making use of embedded losses. Remember, the lower a taxpayer's adjusted gross income (AGI), the higher possibility of deducting medical expenses (subject to a 7.5% of AGI floor) and miscellaneous deductions (subject to a 2% of AGI floor).
Protecting an asset
A long-time client had a substantial holding in a public company, and his cost basis in this investment was very low. Since this particular position comprised almost 25% of his portfolio, we were concerned about the adverse impact this particular stock could have on his overall net worth. Using options available on this stock, we wrote covered calls to generate additional income for the client, never exposing more stock to possible sale than we were willing to sell at any one time. We would often use a portion of the covered call premium to then purchase put options, thereby protecting the downside risk of the stock. Over time, this strategy provided additional income while protecting the large position, and allowed us to slowly reduce the position in order to build a more diversified portfolio.
Reducing stock exposure
After several years with a public corporation, a client had accumulated a substantial position in the company's stock options, and the company stock price had done quite well over the previous few years. The client was concerned about the tax liability she would incur if most of the in-the-money options were to be exercised. She was also participating in the company's non-qualified deferred compensation program. An analysis we prepared showed that the income produced by exercising the options could be offset by deferring the majority of her annual performance bonus. By placing this deferral in the short-term bond option of the deferred compensation program, we managed to reduce the overall volatility of the portfolio and avoid a hefty increase in income taxes.