Viewpoints on Financial Planning
Qualified retirement plan balances are often one of the largest, if not the largest, asset holdings on a family’s balance sheet. When one leaves an employer, he or she has three choices:
- Keep any retirement funds in the company’s plan
- Roll over the assets to an IRA
- Pay out the funds and incur immediate tax consequences
Keeping the funds in an employer plan doesn’t trigger immediate tax consequences and allows for continued tax-deferred growth, but would limit investment options to those offered under the plan. Rolling over the funds to an IRA eliminates immediate income tax consequences, provides for continued tax-deferred growth and affords the potential for wider investment options. Taking the funds out of the plan results in immediate income tax consequences taxable as ordinary income (absent after tax contributions to the plan) and if the employee is under 59½, an additional penalty of 10% may be payable, as well.
If, however, the distribution is treated as a lump-sum distribution (see FAQ #1) of all plan assets and includes appreciated employer securities, the employer stock would be subject to tax at the cost basis of the stock to the plan and not the fair market value of the stock. The difference between the cost basis and fair market value at distribution is known as net unrealized appreciation (NUA). NUA is not taxed until the security is sold, and then is treated as a long-term capital gain (15% maximum federal tax rate in 2013 for most clients, 20% for taxpayers in the 39.6% federal income tax bracket) plus state income tax, if any).
FREQUENTLY ASKED QUESTIONS
1. What is a lump-sum distribution?
A lump-sum distribution is the distribution or payment in one tax year of a plan participant’s entire balance from all of his or her employer’s qualified plans of one kind (for example, pension, profit sharing, or stock bonus plans) and is payable under one of the following circumstances:
- Separation from service (not available to self-employed individuals)
- Attainment of age 59½
- Participant’s death
- Disability (a potential triggering event for self-employed individuals)
Even if not a lump-sum distribution, NUA treatment is available for any securities distributed from a plan with after-tax (non-Roth) contributions.
2. What is includable as employer securities and potentially eligible for the benefits of net unrealized appreciation tax treatment?
To qualify for NUA tax treatment, the distribution must include employer securities. This definition is broader than it seems and includes stocks and bonds with interest coupons or in registered form. It also includes a parent or subsidiary corporate relationship as well as the stock of a predecessor corporation so long as the predecessor corporation was the employer at the time of plan contribution.
Example: Daniel was employed by ABC and was a participant in their qualified retirement plan that was partially funded with ABC stock. A few years ago his division spun off and his retirement account transferred to a new plan with XYZ where he has since been employed for the last 10 years. Daniel retired earlier this year and took a lump-sum distribution of his qualified plan benefits, including some retained and appreciated shares of ABC. This distribution of ABC stock would qualify as a distribution of employer securities.
3. What is net unrealized appreciation and why is it important?
A special tax treatment is available when a lump-sum distribution that includes employer securities is made to a plan participant. Under this provision, the taxable amount of the distribution will be equal to the cost basis (less any after tax contributions made to purchase these shares) and would be taxed as ordinary income. The difference between the cost basis and fair market value at distribution is known as net unrealized appreciation (NUA). NUA is not taxed until the security is sold.
Depending upon the holding period subsequent to plan distribution, the taxation of any gains, post distribution, would be treated as short-term capital gain (39.6% maximum federal tax rate in 2013 plus state income tax, if any), or long-term capital gain (15% maximum federal tax rate in 2013 for most clients; 20% for taxpayers in the 39.6% federal income tax bracket, plus state income tax, if any).
Example: Rebecca, age 60, is about to retire and receive a distribution of her profit sharing plan equal to $500,000 and all-in employer securities. The cost basis to the plan was $150,000. She receives a 1099-R from the plan showing a total distribution of $500,000 and a taxable amount of $150,000.
Assuming Rebecca does not roll over the plan to an IRA, she would have to report $150,000 of the distribution (cost basis of the employer securities) as ordinary income while income taxation on the $350,000 of NUA would be deferred until sold and then taxed as a long-term capital gain. If Rebecca holds the stock for four months post distribution and sells the shares for $525,000, she would report $350,000 of long-term capital gain and $25,000 of short-term capital gain.
4. Can a plan participant elect to split a lump-sum distribution so some of the cash and employer securities are rolled over to an IRA and utilize NUA on the balance?
Yes. In many cases, distributions from qualified plans may include funds other than employer securities. In such a case, a plan participant can utilize an IRA rollover for cash and other securities and potentially benefit from NUA tax treatment on some or all of the distributed employer securities. If the employer securities were rolled over to an IRA, NUA treatment is lost and all future distributions would be taxed as ordinary income.
Example: Jason, age 62, is taking a lump-sum distribution from his employer’s retirement plan. The total value of this distribution is $500,000, $100,000 of which is employer securities with a basis in the retirement plan of only $10,000.
If Jason rolls over the full $500,000 to an IRA, any future distributions would be taxed as ordinary income. However, if he elects to roll over only $400,000 of other securities and has the $100,000 of company stock distributed directly to him, he would report $10,000 as ordinary income in the year of distribution and defer the tax on the $90,000 of NUA until ultimately sold when it would be reportable as a long-term capital gain.
5. What are the estate tax ramifications of NUA?
100% of the value of the stock is includable in the estate of a decedent and therefore potentially subject to federal and/or state death taxes when the taxable estate exceeds the decedent’s unused exemption amount. Unlike most capital assets, NUA is not eligible for a step-up in income tax basis to heirs. NUA is considered income in respect of a decedent (IRD) and not entitled to a step-up in basis.
Example: Joseph received a lump-sum distribution of employer securities when the stock was worth $40 per share and had a cost basis to the plan of $10 per share. At the time of Joseph’s death, the stock was worth $100 per share. His beneficiaries would receive a partial step-up on basis equal to the appreciation post plan distribution ($60 per share) giving them a cost basis in the stock of $70 per share and eliminate all income tax consequences on that amount when sold. The beneficiaries would pay capital gains taxes on the $30 of NUA and would be entitled to an income tax deduction for the estate taxes paid, if any, on the $30/share of NUA when sold.
The decision whether to utilize NUA or roll over is dependent upon a careful weighing of a number of factors. Those favoring an IRA rollover might include:
- Minimal NUA
- Long investment horizon before required minimum distributions must begin
- Concern about equity concentration
- Potential early distribution penalty
- Higher marginal tax rate on ordinary income
Factors favoring utilizing NUA might include:
- Substantial NUA
- Short investment horizon before required minimum distributions must begin
- Adequate current portfolio diversification
- Adequate liquidity to cover the ordinary income taxes due upon distribution
- Charitable inclinations
NUA tax treatment is not an all or none situation. In some cases, with low-basis employer securities distributed as part of a lump-sum distribution, the best choice is a combination. Rollover to an IRA enough employer securities and other assets to build a diversified portfolio geared toward long-term income needs. The remaining stock can be held outside the IRA and available to cover short-term needs, accept a higher level of investment risk and/or be available to fulfill charitable desires.