His Former Employer’s December Dividend Could Add $1.64 Per Share to His 401(k) — But It May Not Turn Into Cash

Quick Read

• When a 401(k) holds employer stock, dividends often remain inside the plan and either boost the fund’s value or buy more shares. If the plan pays them out in cash, they are usually taxable.

• Taking company stock out as a lump sum into a taxable account can preserve favorable capital-gains treatment on appreciation, while rolling it into an IRA generally removes that benefit.

• Large withdrawals can also affect Social Security taxation and trigger Medicare premium surcharges, and a heavy UPS concentration carries risk because the stock has fallen about 47% over five years even as dividends have increased.

• Big 401(k) choices often get made once and then left alone: when to roll over, what to hold, and when to start withdrawals. That is why the report: 401k & IRA Tips and Answers was created, and it is free for now. (Sponsor)

Imagine a 66-year-old former employee who left years ago but still has a large chunk of his 401(k) invested in his old company’s stock. Even though he no longer works there, the company’s decisions still affect his retirement account.

Suppose that account holds the equivalent of 1,000 UPS shares, worth about $108,000 at recent prices. If the quarterly dividend on that stake is $1.64 per share, the payout would total $1,640 for the quarter, or $6,560 a year if the rate stays unchanged. Whether that money ever reaches his checking account depends on plan rules many participants never read.

Where the Dividend Goes

Many retirement plans that offer employer stock keep those shares inside a company-stock fund. In that setup, participants own units in the fund rather than the shares directly, and the stock remains in the plan’s name. Dividends from UPS go to the plan trustee, and the fund’s rules determine whether the dividend increases the unit value or is used to purchase additional shares.

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For many Americans, saving in a 401(k) only creates more questions. Should the account be rolled into an IRA, and if so, when? What happens if a rollover check is made out incorrectly? When do required withdrawals begin, and how much must be taken?

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Some plans let participants receive employer-stock dividends in cash. Those payments are generally taxed as ordinary income in the year received. Qualified employer-stock dividends are also exempt from the 10% early-withdrawal penalty, though the 66-year-old in this example would already be exempt because of his age. If the dividend is reinvested, it remains tax-deferred; if it is paid out in cash, it creates taxable income for the year.

Company Stock Comes With a Hidden Tax Choice

Over the years, the retiree accumulated employer shares through paychecks, often at prices far below today’s levels. The plan tracks the shares’ cost basis, meaning what was originally paid for them. The increase in value while they were held in the plan is called net unrealized appreciation, or NUA.

For example, if he owns $100,000 of employer stock with a $40,000 cost basis, a qualifying lump-sum distribution that moves the shares directly into a taxable brokerage account would generally cause the $40,000 basis to be taxed as ordinary income in that year. The remaining $60,000 of NUA would then qualify for long-term capital gains treatment when the stock is sold. To qualify, the transaction must meet IRS rules, including distributing the eligible plan balance within one tax year.

If the shares are rolled into an IRA instead, that special treatment is lost. The entire amount, including the appreciation, is eventually taxed at ordinary income rates.

Withdrawals Are Where the Tax Bill Shows Up

Dividends that stay inside a traditional 401(k) remain tax-deferred until the money comes out. Suppose he later withdraws $6,560 and is in the 22% tax bracket. Suppose also that his income is already at the point where each extra dollar causes 85 cents of Social Security benefits to become taxable.

Under those assumptions, the withdrawal would add $12,136 of taxable income and about $2,670 in federal tax. That works out to an effective rate of nearly 41%. The result will differ for retirees in other tax brackets or below the Social Security thresholds.

Medicare can add another layer of cost. The income-related monthly adjustment amount, or IRMAA, is generally based on income from two years earlier. For a later year, the first surcharge begins above $109,000 for individual filers or $218,000 for married couples filing jointly, adding $81.20 a month to Part B. The taxable basis included in an NUA distribution can also push income over that line.

A Growing Dividend Can Hide a Shrinking Stake

UPS is a good example of how that can play out. Its quarterly dividend rose from $1.02 in 2021 to $1.64. Yet over the five years through early November, the stock fell about 47%. Its roughly 6% yield is partly the result of the lower share price.

When a former employer makes up a large share of a 401(k), one company’s performance can steer the whole retirement account. Diversifying across several dividend-paying stocks can reduce the damage if one holding weakens. That idea is behind a dividend ladder, which spreads investments across sectors and payment months.

Three Moves to Make Before Touching Company Stock

1. Ask the plan administrator for your cost basis in writing, then run the NUA calculation before any rollover. The lower the basis compared with current value, the more potential tax savings NUA may offer.

2. Find out whether your plan reinvests dividends or pays them in cash. If the plan pays cash, include that amount in your income estimate and check whether it could push you above IRMAA limits two years later.

3. Calculate what share of your 401(k) is tied to former-employer stock. Selling inside the plan usually does not trigger immediate tax, but it can eliminate the chance to use NUA on those shares. Compare the tradeoff before making changes.

A dividend credited inside a 401(k) can increase the account’s value without putting cash in your hands. What you ultimately keep depends on how the money is withdrawn, the federal taxes owed, and whether the distribution increases Social Security taxes or Medicare premiums.

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