Retirement Plan Tactic
Separate employer stock from other assets before a rollover into an IRA
If you leave your job, rolling your company retirement fund into an IRA often makes sense. You can keep tax deferral on the earnings and take control of future investing.
But there are exceptions. One applies if you hold appreciated company stock in the plan.
Such shares qualify for a prime tax break. But that tax benefit will be lost with a full IRA rollover.
A better strategy might be to withdraw your company stock. And roll the rest of your retirement account to an IRA.
To understand the value of this maneuver, you should understand how your company stock will be treated.
When you leave an employer and withdraw company stock, you’ll owe tax. But you won’t owe tax on the current value. The tax will be due on the cost basis of those employer shares. That is the cost of the shares when they went into your account. The plan administrator can supply you with this information.
Let’s say a hypothetical Bill Harris leaves his employer to take a new job. He has $500,000 in his 401(k) plan.
That includes $200,000 of company stock. The basis of those shares is $40,000.
Harris can withdraw his company shares. He’ll owe tax on $40,000.
The other $300,000 can be rolled to an IRA.
Why would Harris want to pay tax now on that $40,000? Such tax will be paid at ordinary income rates as high as 35%.
If he’s younger than 55, he’ll also risk getting hit with a 10% early-withdrawal penalty.
That penalty will apply to the cost basis.
So if Harris is 50 years old, he will likely owe an additional $4,000: 10% of $40,000.
But Harris may be willing to pay that much now. That would entitle him to a tax break on the $160,000 that has not been taxed. His $160,000 is called the net unrealized appreciation (NUA).
Special Status
The NUA will not be taxed until the shares are sold. And the profit will be taxed as long-term capital gains. Currently, that tax will be no higher than 15%.
If Harris had rolled over his entire 401(k) account to an IRA, the NUA opportunity would have been lost. All IRA withdrawals will be taxed at ordinary rates.
In our example, Harris now holds $200,000 of company stock in his brokerage account. That is $40,000 of basis and $160,000 of NUA.
He can sell that stock immediately. The NUA will be taxed favorably, as a long-term gain.
Or he can hold his shares for a while.
Say he sells when the shares have dropped in price from $200,000 to $150,000. Harris’ basis is $40,000, so he would have a $110,000 taxable gain, taxed at 15%.
On the other hand, suppose Harris sells when the shares have gone up to $250,000. Now his taxable gain is $210,000 – $250,000 minus his $40,000 basis.
Of that $210,000, the first $160,000 will be a long-term gain.
The other $50,000 also may be a long-term gain. That will be the case if it has been more than one year since the shares were withdrawn from the plan.
At some point, Harris should sell the shares withdrawn from the plan. If the shares are held until death, the heirs will owe capital gains tax on the NUA, when they sell the shares.
Selling NUA shares may allow Harris to retain other holdings. On other appreciated assets under current law, the capital gains obligation dies with the owner.
Some requirements apply to the NUA tax shelter.
You must take a lump-sum distribution. All of the assets in your company retirement account must be withdrawn within one calendar year.
But you don’t have to withdraw all of your employer stock to use the NUA tax break. The greatest advantage comes when the shares have been highly appreciated.
So it make sense to withdraw only the low-basis shares. You may be able to do that if your company has kept accurate records.
Suppose that Harris is in the 35% tax bracket. He doesn’t want to pay 35% tax plus a 10% penalty on his $40,000 basis in his company shares.
Strategic Steps
But his company keeps good records. Harris sees that $100,000 of company stock went into his plan a long time ago, so it has only a $5,000 basis.
The other $100,000 has a $35,000 basis,
Harris can direct the plan administrator to distribute the $100,000 of low-basis shares to his brokerage account.
He will owe tax and penalty on only $5,000.
And the other $400,000 in his 401(k) can be rolled to his IRA.
The greater the spread between the cost basis and the current value of the shares, the more valuable the NUA tax break will be.$
Author-Bio: Ray Buckner (Chicago, Illinois) provides personal financial planning and wealth management services for professionals in the greater Chicago metropolitan area. His primary focus is serving pre-retirees who are preparing for a successful retirement as well as those who have already retired and want to develop a 100% retirement income personal paycheck. His pre-retiree clients want to focus on replacing 100% of their last year s income and keep their current standard of living through out their retirement adjusted each year for inflation.
www.promoneyreports.com/rbuckner
