When a qualified retirement plan account holds employer stock, a retirement plan participant could potentially save thousands of dollars with proper planning. As clients face triggering life events such as separation from service and retirement, questions regarding the next steps for treatment of retirement accounts will be at the forefront of their minds. At retirement, it is common for an individual to make a tax-free rollover of a 401(k) into an individual retirement account (IRA). This can allow for more flexibility and the ability to further diversify investment holdings. However, an individual can miss a tax planning opportunity if the 401(k) was composed of employer stock.
A previous article in The Tax Adviser discusses the favorable tax rules that apply when a lump-sum distribution is composed in whole or in part of the employer corporation's securities (Ellentuck, "Planning for Distributions of Employer Securities," 38 The Tax Adviser 419 (July 2007)). The net unrealized appreciation (NUA) on the employer stock is not taxed upon distribution. NUA is the excess of the stock's fair market value (FMV) over the cost basis of the securities.
In this situation, ordinary income tax is due at the time of distribution on the original cost of the company stock inside the 401(k) plan. Tax is deferred on the NUA until the stock is sold, and the NUA is taxed at capital gains rates. In comparison, if the stock is rolled directly into an IRA, the NUA loses its long-term capital gain character and is taxed at ordinary income tax rates when distributed from the IRA. Bear in mind that any appreciation beyond the NUA is taxed as a capital gain based on the holding period starting from the date the stock was received as a distribution from the qualified plan under Regs. Sec. 1.402(a)-1(b)(1)(i) and Notice 98-24.
If the account consists of both employer securities and outside investments, a taxpayer can take a lump-sum distribution of the employer stock and contribute the nonemployer stock or other remaining amounts to an IRA within 60 days of the distribution to qualify as a tax-free rollover.
The deferral of tax on NUA can be a particularly significant benefit if:
- The client is highly compensated;
- The employer stock has significantly appreciated; or
- The client does not plan to sell the employer stock for some time.
Although the fundamental rules regarding these provisions have not changed, tax brackets have. Since 2007 the maximum ordinary income rate has increased from 35% to 39.6%, and the maximum long-term capital gains rate has increased from 15% to 20%. In addition, the 3.8% net investment income tax could apply. Example 1 shows an all-or-nothing calculation at the highest applicable tax rates. Example 1 shows a clear comparison of federal taxes assuming that the individual is in the highest tax bracket when the funds are distributed or the stock is sold.
Example 1. Highest tax rates: A qualified retirement plan contains 100% employer stock (10,000 shares) and zero after-tax contributions. The balance of the plan at termination is $1 million with a $500,000 cost basis in the stock. FMV in five years is $2,500,000. This analysis assumes the individual is in the highest tax bracket when the funds are withdrawn and that the stock is held for five years after the termination or retirement date.
If a lump-sum distribution of the entire amount of stock is made at termination, $500,000 would be income in the year of distribution ($1 million FMV less $500,000 cost basis). Assuming the highest tax bracket is applied, this would be taxed at a 39.6% ordinary income tax rate resulting in $198,000 in tax upon distribution. Five years later when the stock is sold, $2 million is recognized as income (the NUA of $500,000 and the appreciation after the lump-sum distribution of $1,500,000) and taxed at the more favorable long-term capital gain rate of 23.8%. Total taxes paid by holding the stock would be $674,000 ($476,000 + $198,000). If the stock was rolled over into an IRA upon termination, assuming the distributions were taxed at the highest ordinary income rate of 39.6%, the tax would be $990,000. Taking the lump-sum distribution saves the client $316,000.
If a client has more flexibility when it comes to his or her income, bracket management can be used to make the tax benefit of the lump-sum distribution planning opportunity even better. Also, a client might not be able to afford paying the tax upon the distribution of all employer stock. If the client does not have the liquidity and has to sell some of the stock, a portion of the benefit can be lost. Example 2 illustrates the benefits of smaller strategic distributions and stock sales to maximize the after-tax cash from the 401(k) employer stock. The IRA distributions are assumed to be strategically withdrawn to ensure they are not taxed above the 25% tax bracket, as well.
Example 2. Bracket management: Assume the same facts as Example 1. A 401(k) plan contains 100% employer stock (10,000 shares) and zero after-tax contributions. The balance of the plan at termination is $1 million with a $500,000 cost basis in the stock. FMV in five years is $2,500,000. In this comparison only 3,000 shares are initially distributed (FMV of $300,000) with the assumption that a reduced ordinary income rate of 25% would apply. The remaining 7,000 shares are rolled over into an IRA. Assume the value of the shares at the time of sale and distributions from the IRA are consistent, and the sales or distributions are done to keep the average rate at 25% for ordinary income and 15% for capital gains.
The $150,000 of cost basis in the lump-sum distribution of stock is taxed at the 25% tax rate, resulting in $37,500 of tax. The estimated tax on the gain from the future sale of the lump-sum distribution of stock ($600,000 × 15% = $90,000) and IRA distributions of the remaining stock rolled over to the IRA ($1,750,000 × 25% = $437,500) in the lump-sum distribution scenario is approximately $527,500. The total tax in this scenario is $565,000. For the rollover scenario, it is assumed that the value of the stock remains at $2.5 million and that distributions are taken over time with a maximum tax rate of 25%. This scenario results in an estimated tax of $625,000. The overall tax benefit of the lump-sum distribution approach in this example is $60,000.
The strategic income tax advantages of taking employer securities from an employer-qualified plan call for careful financial planning with clients. Each individual's situation is different, and the risks and rewards can vary significantly. The lump-sum distribution strategy is uncommon and could create great tax savings as your clients retire or transition to a new company.
Michael Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.