As people retire, they will often have a choice of leaving funds with their previous employer or rolling over the funds to an individual retirement account (IRA). An IRA is somewhat like a pension or profit sharing plan, in that it allows the funds to be held tax-deferred until later withdrawn. Although there are differences, in general, from a distribution perspective, IRAs and profit sharing plans share many commonalities. From an asset protection standpoint, however, ERISA plans (i.e., profit sharing and pension plans) generally provide enhanced asset protection (discussed on the following pages).
The key question one faces after retirement is the determination of whether or not funds should be moved from an ERISA-governed plan to an IRA. The primary answer to this question will be based on asset protection, while the secondary answer will largely be governed by federal tax law.
In certain circumstances, an employee who plans to separate from service (or has already separated from service) after age 55, but who is not already age 59½, may be well-advised to leave funds in an ERISA-governed qualified plan until he reaches age 59½. This can be beneficial because distributions from qualified plans are not subject to the 10 percent additional tax on early distributions if the plan participant is over the age of 55 at the time of separation, while distributions from IRAs are subject to such penalty unless the IRA owner has reached age 59½.
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1. Lump Sum Distributions
For certain older taxpayers, special tax breaks exist for qualified retirement plan (e.g., 401(k), profit sharing, pension, or stock bonus) distributions which are taken pursuant to a lump sum distribution. In general terms, a lump sum distribution is simply a distribution of the entire qualified retirement plan balance to the taxpayer within one tax year.
However, in order to obtain special tax treatment under the lump sum distribution rules, the following must occur:
1. The distribution must be taken from an exempt trust (i.e., 401(k), profit sharing plan, etc.);
2. The entire plan balance must be paid to the retiree (i.e., plan participant);
3. The entire distribution must take place within one tax year (i.e., by December 31); and
4. The qualified plan balance must be payable to the taxpayer “on account of” (upon) one of the following triggering events:
b. Attainment of age 59½;
c. Separation of employee from service; or
Notably, in order for the lump sum distribution rules to apply, the distribution must be from an employer retirement plan; a distribution from an IRA is never eligible for lump sum distribution rule treatment.
2. Net Unrealized Appreciation (NUA)
In the area of retirement distribution planning, one of the most often overlooked hidden gems in the tax law is net unrealized appreciation (NUA). In short, when a retiree opts to take a lump sum distribution of employer stock from his employer’s qualified retirement plan, he is afforded special capital gains tax treatment. That special treatment is available on the difference between the fair market value (FMV) of the employer stock at the time of rollout and the cost basis of that stock. In essence, the retiree is converting what would otherwise be ordinary income into long-term capital gains.
While very few will, or should, take a 100-percent distribution of employer stock from a qualified retirement plan, to not take any employer stock out of the plan may be imprudent. As such, the ultimate decision will often lie somewhere between 0 percent and 100 percent. Example: In 2009, John, age 60, took a lump sum distribution of 5,000 shares of Blackacre Corp stock (employer stock) from his employer qualified retirement plan. The qualified plan trustee’s cost basis in the stock was $10 per share and the FMV of the stock at the time of rollout was $100. In this case, John would pay income tax, at ordinary income tax rates, on the $50,000 cost basis (5,000 shares x $10/share) of the employer stock in the year of distribution. The $450,000 of NUA on the employer stock [($100 FMV - $10 cost basis) x 5,000 shares], however, is not taxed until John sells the stock at a later period in time. When it is ultimately sold, the NUA gain of $450,000 will be taxed at long-term capital gains rates.
Along with the above considerations, one of the key issues to address in determining whether to take employer stock from a qualified retirement plan is whether it makes sense to pay an immediate income tax on the cost basis of the employer stock rolled out of the plan versus deferring the income tax by rolling the stock over to an IRA. From a pure tax perspective, the decision whether to roll out employer stock will largely depend on: (1) the cost basis of the stock as a percentage of FMV, (2) the income tax rate differential between ordinary and capital gain income, and (3) the client’s time horizon over which he will be selling the stock or taking IRA distributions.
Investment risk in a rollover situation can be mitigated by choosing to sell the stock immediately after the distribution from the employer retirement plan. However, if this is accomplished with a NUA distribution, it will potentially result in a significant immediate income tax liability – one that may have been significantly deferred if the retiree had instead rolled the funds into an IRA, diversified out of the stock without a tax liability (due to the tax deferral of the IRA), and postponed withdrawals for many years (or even decades) until the funds were needed.
Example: Jane, age 56, currently has $1,250,000 in her qualified retirement plan, of which 80 percent consists of employer stock. In addition to her qualified retirement plan, Jane has $50,000 in a traditional IRA and $200,000 in a taxable investment account, both of which are highly diversified. In this situation, it would not be advisable, from a diversifiable risk standpoint, for Jane to take all of the employer stock out of the qualified plan in that over two-thirds of her retirement investment portfolio consists of a single stock, unless she is prepared to sell most or all of the stock immediately and incur the associated tax liability.