By Marvin Rotenberg, IRA Technical Expert
There is a little known provision in the tax code that can provide a huge income tax advantage in the right circumstances. If you own highly appreciated company stock in an employer-sponsored retirement plan, such as a 401(k), consider withdrawing some or all of the stock and rolling the rest of the plan assets into an IRA when you retire or leave the company. This way, you’ll pay no current income tax on the stock’s appreciation (known hereafter as net unrealized appreciation or “NUA”) or on the amount rolled over to your IRA. The only income tax you'd pay in the year of distribution would be on the cost basis of the stock. The cost basis is the aggregate amount expended to purchase the stock inside the plan. The plan administrator will provide you with the cost basis value as well as the amount of the stock’s NUA.
The higher the amount of appreciation, the more advantageous the company stock income tax break becomes. It becomes even more advantageous if the plan participant is age 59 ½ or older (or was age 55 or older when they separated from service) when the distribution is made, as the early distribution penalty equal to ten percent of the taxable portion of the payout will be avoided. This penalty is also avoided if payment is made due to the participant’s death.
The plan participant (or beneficiary) can elect to defer the tax on the NUA until the stock is sold. Whenever the sale occurs, it will be taxed as a long-term capital gain, which for 2012 is at a maximum rate of fifteen percent. The one-year holding period necessary to qualify for long-term capital gain treatment is automatically deemed satisfied, regardless of how long the stock is held outside the plan. Also, while NUA is considered income in respect of a decedent (IRD) and does not receive a step-up in basis, any appreciation earned after the stock is distributed from the plan is eligible for a step-up, under current rules.
To qualify for NUA treatment, the payment from the plan must be a “lump-sum distribution.” A lump-sum distribution requires all of a participant’s account balances in all like plans of the employer (i.e. all profit sharing plans – including 401(k)s and stock bonus plans, or all pension plans, etc.,) to be distributed in one calendar year, resulting in a zero balance by December 31. Also, the distribution must be on account of a triggering event. These triggering events are the participant’s:
2. attainment of age 59 ½ (if the plan allows payments at this time)
3. separation from service (not for self employed)
4. disability (for self employed only)
Although conventional wisdom generally says that all assets distributed from an employer-sponsored plan should be rolled over to another retirement account in order to maintain their tax-deferred status, the availability of NUA treatment on company stock requires careful consideration, particularly in cases where the appreciation is significant. Once company stock is rolled over to an IRA, the NUA opportunity is lost forever. This is where the value an advisor who is highly-trained in this specialty area can be realized, potentially saving you and your family thousands of dollars.