From the August 2007 issue of Boomer Market Advisor • Subscribe!

The advisor voice - a huge tax-saving opportunity

Rolling your clients' appreciated company stock out of their 401k plans into taxable investment accounts -- combined with charitable giving -- provides a huge tax-saving opportunity.

For years the IRS has allowed special tax treatment of company stock acquired through employer-sponsored retirement accounts, allowing capital gains taxation on appreciated stock (instead of taxing distributions as income). If the stock transfer is properly executed, gains in the company stock become categorized as "net unrealized appreciation." A description of how NUA works can be found in James Lange's recent article, "Avoid costly boomer rollover mistakes" (Boomer Market Advisor April 2007). In short, the only taxes owed will be based upon the cost basis, which is taxed as ordinary income. All of the stock's gains are NUA and will be taxed at long-term rates when sold.

Gifting strategy one: $50,000 current gift

Assume a client age 60 is retiring from a public company. She has $500,000 of company stock in her 401k plan with a cost basis of $50,000. Her AGI places her in the 35 percent tax bracket, and she wants to make a gift of $50,000 to her favorite charity.

If she uses the NUA strategy to transfer $50,000 of her stock to a taxable account, and then gives that stock to the charity, the tax cost for the transfer is $1,750 (35 percent of her cost basis), but this would be "paid for" by the $50,000 deduction for her gift -- leaving her with a tax refund of $15,750.

If she chooses to roll her 401k assets into an IRA, she could take a distribution from the IRA and gift $50,000 - but income from the distribution and the deduction for the gift will offset each other -- for a net tax benefit of $0. For clients over age 70 1/2 in 2007 who want to give to a charity directly from their IRAs, the tax benefit is still zero (you don't get a charitable deduction for the qualified contributions). In this example, the NUA strategy provides a "tax alpha" of $15,750 over the IRA strategy.

She could also write a check to the charity from her checking account and get a $50,000 deduction for the year -- leaving her with a tax refund of $17,500 ($1,750 more than the NUA strategy) -- but consider the following:
If she gifts the stock directly and pays for the tax cost of the NUA conversion from her checking account ($1,750), she has $48,250 left to invest -- let's assume in a mutual fund earning 8.5 percent per year. At the end of 30 years, her beneficiaries get a $558,000 investment they can immediately sell with zero tax liability.

If she keeps the same $50,000 in her IRA she will end up with $580,000 at the end of 30 years, but distributions are all taxed as ordinary income, netting her beneficiaries only $377,000. That's over $180,000 more to the beneficiaries by just changing the source of the $50,000.

SB: Gifting strategy two: Adopt the NUA strategy and gift the entire $500,000 to a CRT

If you want to make a significant contribution to a charity, but also need current income, combine NUA with a charitable remainder trust.

  • Taxes owed for NUA strategy: $17,500 (35 percent of her cost basis)
  • Tax deduction (unitrust with an 8.5 percent payout rate): $118,750
  • Annual income: $42,500 ($36,125/year after taxes)
  • Total after-tax income from trust: $1,119,875 (assuming 31 years of payments)
  • Final amount to charity: $500,000

A $500,000 IRA account, growing at 8.5 percent, would have to distribute $55,577 per year to equal the after-tax income from the CRT. Instead of enjoying 30 years of income and leaving $500,000 to her favorite charity, the IRA owner will run out of money at age 77 -- after only distributing $641,005 (after-tax). Instead of supporting a charity that helps the poor, she will end up a candidate for charitable support for the final 13 years of her life.

Even for those that have no charitable intentions and are concerned only with the income they get in retirement, the CRT strategy is still compelling. As a means to achieve diversification without the tax hit associated with selling appreciated shares, a CRT is a great idea.

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