What You Need to Know
- The DOL’s proposed rules would put advice regarding IRA rollovers under the scope of fiduciary investment advice.
- The tax implications surrounding whether to roll a 401(k) distribution into an IRA are a key factor, but there are often other considerations.
- Net unrealized appreciation is a popular distribution option for company shares held in a 401(k), but it is not the right choice in all situations.
The Department of Labor’s proposed new fiduciary rules indicate that advice on individual retirement account rollovers from 401(k) plans and other retirement plans is fiduciary advice.
This also covers advice on lump-sum distributions, including whether to use the net unrealized appreciation option when applicable.
As IRA expert Ed Slott recently pointed out, when an investor is seeking advice on what to do with their 401(k) at retirement, understanding the tax consequences of each option is a crucial part of giving advice in their best interest.
Let’s review the tax and other considerations for various IRA rollover and retirement plan distribution options.
Net Unrealized Appreciation (NUA)
If you have clients who hold company stock inside their 401(k), you should look at the net unrealized appreciation option when they leave their employer.
With that option, clients can elect to take a distribution of company shares held inside the 401(k) and then roll over any other assets in the 401(k) to an IRA if they wish. The potential advantage of this strategy is that clients would pay taxes on the cost basis of the shares. The difference between the current market price of the shares and their cost basis is the net unrealized appreciation.
If they hold the shares for at least a year and then sell them, the gains would be taxed at preferential long-term capital gains rates on the difference between the sale price and the cost basis.
This can be a great strategy for clients with company shares in their 401(k), but it is not a no-brainer.
Some cautions when deciding if net unrealized appreciation is appropriate include:
- What is the difference between the current market price of the stock and the cost basis? If it is relatively small, then using net unrealized appreciation and having clients pay the tax on the cost basis amount may not be advantageous.
- Does it look like the stock will hold its value or appreciate over the next year? Net unrealized appreciation loses its appeal if the stock’s price drops shortly after using this option.
- Will the client meet the requirements to use net unrealized appreciation, including completing the entire distribution of the 401(k) account within one year?
- Stock given the net unrealized appreciation treatment does not qualify for a step-up in basis when the owner dies. Heirs would have to use the original basis, which could lead to a higher tax bill.
- Consider the amount of taxes the client will need to pay on the cost basis of the shares.
Traditional 401(k) to Traditional IRA Rollover
This type of rollover is common and mostly straightforward. As long as the rollover is done properly, there are no immediate tax implications. Taxes are due when funds are withdrawn, including for required minimum distributions. For many clients this might be the right option when rolling over their 401(k), 403(b) or other retirement plan.