Many businesses incentivize their employees by allowing them to buy employer stock inside their 401(k) plans. While this provides tax savings on the front end, some employees don’t realize that the money is taxed as ordinary income when it’s withdrawn (as opposed to the more favorable capital gains tax rates).

What Is the Difference Between Long-Term Capital Gains and Ordinary Income?

Long-Term Capital Gains

Long-Term Capital Gains Tax Rate(Single) Taxable Income Over(Joint) Taxable Income Over
Source: Internal Revenue Service (IRS)

Ordinary Income

Ordinary Income Tax Rate(Single) Taxable Income Over(Joint) Taxable Income Over
Source: Internal Revenue Service (IRS)

As you can see, long-term capital gains are taxed at much lower tax rates than ordinary income. In many cases, it is advantageous to make sure your capital gains qualify as long-term to lock in profit and less taxes upon sale. In certain instances (such as the one below), you may be able to shift income that would have been taxed as ordinary income to the more advantageous long-term capital gain rates.

There is a special tax strategy that lets employees make an election which allows the stock appreciation from employer stock held inside their 401(k) to escape the hefty ordinary income tax rates. The appreciation is instead taxed as capital gains. This strategy involves disbursing the 401(k) to an IRA and then utilizing the “Net Unrealized Appreciation” rules.

In the right circumstance, taxpayers can save significant taxes. Let’s say you transferred $140,000 worth of securities ($20,000 basis and $120,000 unrealized appreciation) – which was previously held hostage in a 401(k) – to an IRA. If you had an effective tax rate of 22%, you would pay ordinary income tax of $4,400 (22% x $20,000). Subsequently, you could maximize the 0% capital gains tax bracket (over the course of three years) and pay $0 in Federal tax on the remaining $120,000 of unrealized appreciation. Had you taken the more traditional approach and withdrawn the money out of your 401(k), you would have owed approximately $26,400 in Federal taxes.

If you have a 401(k) or an IRA and want to learn how to distribute your funds in the most tax-efficient way possible, consider calling your financial advisor.

This is intended for informational purposes only and should not be construed as personalized financial advice. Please consult your financial professional regarding your unique circumstances.

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