When you retire or change jobs, it is generally a good idea to roll over your employer-sponsored qualified retirement plan balances into a traditional IRA.
That way, you avoid an immediate tax hit and continue to benefit from tax-deferred earnings growth until you withdraw money from the IRA.
But that advice may change if the employer-qualified plan account holds appreciated company stock. In that case, you could be better off withdrawing the shares, paying the taxes, and holding the stock in a taxable brokerage firm account. Here is why.
The net unrealized appreciation of the shares goes untaxed until you sell them. As long as the shares are part of a lump-sum distribution from your retirement accounts, you pay current tax only on the retirement plan’s cost basis in the stock. The cost basis is generally the value of the shares when they were acquired by the plan. The net unrealized appreciation is the difference between cost basis to the plan and the shares’ market value on the date they are distributed to you.
If the shares have appreciated substantially, the plan’s cost basis could be a relatively small percentage of the shares current market value as of the distribution date. However, the cost basis could still be significant in absolute dollars, so the tax hit may be more than a nominal amount.
In addition, if you are under 55 years of age when you leave your job, you generally have to pay the 10 percent federal tax penalty on premature withdrawals. That might be worth it, though, if the taxable income, which is equal to the cost basis, is small.
When the net unrealized appreciation is taxed, it automatically qualifies as a long-term capital gain eligible for favorable capital gains rates (see IRS Notice 98-24). As you know, the current maximum federal rate on long-term capital gains is only 20%, compared with a maximum 39.6% on ordinary income.
Additional Tax Savings
Appreciation of the shares after the distribution also qualifies for the favorable capital gains rates, provided you hold the stock for more than 12 months after receiving them from the plan.
Even More Tax Savings
If you own the stock when you die, your heirs are entitled to a federal income tax basis step-up for any post-distribution appreciation. However, when they sell the shares, the net unrealized appreciation will be taxed under the “income in respect of a decedent” rules. The good news is the unrealized appreciation will be taxed at the favorable rates for long-term capital gains. (see IRS Revenue Ruling 75-125)
In contrast, if you roll the employer stock over tax free into an IRA, you pay tax on the stock gains only when the shares are sold and you take withdrawals from the IRA. The net unrealized appreciation and post-distribution appreciation will count as ordinary income, so you or your heirs will owe as much as 39.6% in taxes rather than the favorable capital gains tax. (See right-hand box.)
Before following this tax-saving strategy, be sure the shares qualify and are part of a lump-sum distribution. The rules are tricky, so consult with your tax adviser if you have questions or want to discuss whether this maneuver will work for you.
An Example to Show the Mechanics of the Strategy
Let’s say you retire from your job at age 60. As part of a lump-sum distribution from your company-sponsored, qualified retirement plan, you receive 2,000 shares of employer stock. The shares have a cost basis to the plan of $10,000 and a current market value of $80,000.
You expect the stock to continue to appreciate, so you don’t plan to sell in the near future. Instead of rolling the shares into an IRA, you deposit them in a taxable brokerage house account. You then pay tax at your ordinary rate of, say 25%, on the $10,000 cost basis amount. So the federal income tax hit is $2,500 (25% of $10,000). Since you are older than age 55, you don’t owe the 10% premature withdrawal penalty tax.
Your tax basis in the shares is now $10,000. You can roll over some or all of any other money received in your lump-sum distribution tax-free into a traditional IRA.
Years later, you die after the employer shares have appreciated to $180,000. Your heirs will receive a federal income tax basis step-up equal to the post-distribution appreciation in value ($100,000 in this example).
When your heirs sell the stock, they will owe capital gains tax on the $70,000 worth of net unrealized appreciation ($80,000 market value as of the plan distribution date minus the $10,000 cost basis in the shares). Assuming a 15% capital gains rate, the total federal income tax hit on the $180,000 worth of stock is only $13,000:
- $2,500 paid by you when you received the shares as part of the lump-sum distribution.
- $10,500 (15% of the $70,000 of net unrealized appreciation) paid by your heirs when the shares are finally sold.
- That amounts to an effective federal income tax rate of only 7.22%.
- In contrast, if you had rolled the employer shares over into an IRA, your heirs would eventually owe tax at ordinary income rates on the entire $180,000. In all likelihood, the resulting federal income tax hit would be at least 25%, or $45,000.