Thomas Edison once said, “To invent, you need a good imagination and a pile of junk.”

Given the options that executives have today with regard to their retirement plans, there certainly is no shortage of the latter. The challenge then is to use existing retirement rollover rules as the basis for the development of truly useful solutions.

One rule in particular could be helpful as you work with executives in this area. Well look at that rule here.

Most executives are presented with no more than two retirement options: 1) roll their existing plan assets over to a traditional Individual Retirement Account; or 2) roll over to a Roth IRA (by rolling to a traditional IRA and then immediately converting to a Roth IRA). Lets look at these:

Option One: As you know, by rolling to a traditional IRA, the executive incurs no tax on the rollover but must pay taxes on all subsequent withdrawals at ordinary income tax rates. In addition, minimum distribution rules apply, and the entire IRA is subject to both income and estate taxation at death.

Option Two: If eligible, an executive may instead choose to roll over to a Roth IRA. This will trigger an immediate tax on the conversion amount at ordinary income tax rates, but will allow earnings not only to accrue without taxation, but also to be withdrawn tax-free. Moreover, the Roth IRA is not considered Income in Respect of a Decedent (IRD), so heirs can inherit the plan income tax (though not estate tax) free.

The choice, when available, boils down to paying income taxes on the entire plan up-front, or paying income taxes on the entire plan at the back end.

By choosing to pay sooner, the taxpayer writes a smaller check to the government, but has that much less available to accumulate on a tax-deferred basis. Also, neither rollover option avoids the payment of taxes at ordinary income tax rates. Neither protects against estate taxation. Neither insulates the underlying stock investments from market risk. And neither allows cherished employer stock to be passed to heirs intact.

Now for a solution. Employer stock distributions offer a more tax-efficient alternative to IRA rollovers. Under Internal Revenue Code Section 402(e)(4), when an employee receives a lump sum distribution of securities of the employer corporation, the employee need only pay income taxes on the employers cost basis of the stock.

This cost basis is often significantly less than the fully appreciated value at time of distribution. The difference, or Net Unrealized Appreciation, is not included in gross income. Hence, your executive client receives outright ownership of the shares with a cost basis equal to the employers original stock basis.

Any subsequent sale of these shares, even a day after the distribution, results in taxes based on the more favorable long-term capital gains tax rate.

That is a favorable outcome for the executive right there, but it becomes even more effective if you also guide the executive to use a special type of loan and a fixed annuity. Here is the concept:

If the employer is a large publicly traded corporation, the executive can receive as much as 90% of the value of the shares in cash, without paying capital gains taxes, while at the same time protecting those shares from any unexpected market dips.

This is possible through the use of special non-callable and non-recourse stock loans. These are unique margin loans that are just now starting to become available in certain markets.

Under this concept, the executive makes these special loans and then deposits the proceeds into an annuity with fixed guarantees. (This can be either a deferred or immediate fixed annuity from a highly rated insurer.) The executive then has access to the annuity values, and is assured that the money in the contract is insulated from volatile market conditions.

At the end of the loan term–which may vary by lender–the borrower has the contractual right to either pay back the loan with accrued interest and recover the appreciated shares, or pay nothing to the lender and walk away with the annuity free and clear. (If the executive chooses the latter option, he or she may be required to pay a capital gains tax at the end of the loan term.)

Thus, by electing a 402(e)(4) distribution rather than an IRA rollover, borrowing against the shares using a unique type of stock loan, and depositing the loan proceeds into a fixed annuity, the savvy executive can retain ownership of the employer stock (along with most of the upside gains), achieve 90% liquidity, avoid ordinary income taxes, avoid immediate capital gains taxes, and protect against market risk.

If youve been recommending traditional retirement options that have left your clients grumbling, consider it a learning experience. Edison also said, “I have not failed. Ive just found 10,000 ways that dont work.”

Robert K. Strauss, J.D., is co-chairman of Emerging Money Corporation, Stamford, Conn. He can be e-mailed at bob@stocktocash.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, June 11, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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