If you leave your job with company stock in your 401(k) or another qualified retirement plan account, you might wonder if there's a tax-smart move you can make with the stock. Here's some advice to achieve the optimal tax results over the long haul.
Conventional wisdom suggests that you should roll over any distribution from a company qualified retirement plan account into an IRA. That avoids an immediate income tax hit and allows you to continue to benefit from tax-deferred earnings until you take withdrawals from the IRA.
If you roll over distributed company shares into an IRA, no income tax will be due until you withdraw money from the IRA. However, all the net unrealized appreciation (NUA) and any later appreciation in the value of the company shares will eventually be taxed at ordinary income rates. Under current law, the maximum ordinary income tax rate is 37%. NUA is the positive difference between the current value of distributed company stock on the distribution date and the basis of the stock in your retirement account.
When a qualified retirement plan account holds appreciated employer stock, conventional wisdom might be to roll over the stock as part or all of a lump-sum distribution (LSD). But from a federal income tax perspective it may be better to put the shares into a taxable brokerage firm account and pay a modest current tax hit. Anything else received in an LSD can, and generally should, be rolled over tax-free into an IRA. (See "What Counts as an LSD?" below.)
As long as the distributed company shares are part of what qualifies as an LSD from your qualified plan account(s), only the amount of the plan's cost basis for the shares is taxed currently. A plan's cost basis generally equals the fair market value of the shares when they were acquired for your account.
If the shares have appreciated substantially while held in your retirement account, the cost basis could be a relatively small percentage of current value. That said, the cost basis won't necessarily be an insignificant amount.
If you're under age 55 when you leave your job, the 10% early distribution penalty tax will also generally apply. In most situations, however, the penalty will apply only to a relatively modest cost basis amount as opposed to the full fair market value of the distributed shares.
The cost basis amount will be taxed at your ordinary federal income tax rate, which can currently be as high as 37%. But there are four potential offsetting tax benefits:
For clarity purposes, consider the following example. Amy quits her job at age 40. Her company only offers a 401(k) plan. In a single transaction, she receives an LSD from her 401(k) account that consists of $200,000 of cash and company stock with a current fair market value of $100,000. The cost basis of the stock is $10,000. So, Amy's NUA is $90,000 ($100,000 minus $10,000).
If she rolls the $200,000 of cash into an IRA and keeps the stock in a taxable brokerage firm account, she'll owe federal income tax on the plan's $10,000 basis in the stock. She'll also owe the 10% early distribution penalty tax on the $10,000, because she's under age 55 and doesn't qualify for any of the exceptions to the 10% penalty. Her tax basis in the distributed company stock is $10,000.
Let's assume Amy is in the 24% federal income tax bracket, and she doesn't owe the 3.8% NIIT. The federal tax hit is $3,400 [$10,000 times (24% + 10%)]. But consider the advantages:
What if Amy decides to sell the company stock for $85,000 in five years? Her gain would be $75,000 ($85,000 minus $10,000 basis). Her gain is less than the $90,000 of NUA that existed when the stock was distributed to her. So, her taxable gain is limited to $75,000 — the lesser of 1) the gain on sale or 2) the NUA. Because the gain consists entirely of NUA, it's automatically taxed at long-term capital gains rates.
If you don't receive the company stock as all or part of an LSD and you keep the distributed shares in a taxable account, the current fair market value of the shares will generally be taxed at ordinary income rates. Any subsequent appreciation in the value of the shares will qualify for lower long-term capital gains tax rates if you hold the shares for over a year.
The exception to the above tax treatment is if your retirement account holds some shares that were paid for with nondeductible employee contributions to the plan. In that case, the NUA attributable to distributed shares that were acquired with the nondeductible contributions isn't taxed until the shares are sold, and that amount of gain will automatically qualify for lower long-term capital gains tax rates. Any post-distribution appreciation in the value of those shares will qualify for lower long-term capital gains tax rates if the shares are held in the taxable account more than 12 months.
The rules that apply to post-termination distributions of company stock from a retirement account can be confusing. Plus, Congress could pass legislation that would increase the tax rates on long-term capital gains, which would adversely affect this tax-planning strategy. Contact your tax advisor to determine what's right for your situation.
A lump-sum distribution (LSD) is a distribution, or several distributions, that result in you, the employee, receiving the entire balance from all qualified pension plans, all profit-sharing plans or stock bonus plans within a single calendar year. Multiple payments are permitted as long as they are all received in the same year.
For purposes of the LSD requirement, the following three aggregation rules apply:
Finally, for a distribution to be an LSD, it must be received due to your separation from service, attainment of age 59½ or death. However, if you are 59½ or older, you can receive an LSD without separating from service if the plan(s) permit it.
For example, Zoe receives her entire balance from all company profit-sharing plans in which she participates in several payouts in 2022. Those payouts qualify as an LSD even if Zoe doesn't receive the entire balance from the company pension plan, in which she also participates, until 2023.
In the most common situation — where the employee only participates in a 401(k) plan and receives the entire account balance in one year — you have an LSD even if you receive several distributions to liquidate your account.
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