Proper tax planning and tax preparation considerations are not found when using a commercial tax preparation software package. Just imagine if you could be taxed at long-term capital gain rates rather than ordinary income tax rates on distributions from your employer’s 401(k) plan.
What typically happens when an employee retires or changes jobs? The employee rolls over the 401(k) funds into an IRA. The rollover to an IRA is a non-taxable event and the employee will eventually be taxed at ordinary income tax rates when the employee takes distributions from the IRA. However, this standard practice of rolling over a lump-sum distribution into an IRA to postpone immediate tax liability could prove to be a very expensive mistake. Why?
What few taxpayers realize is that they may have the means to defer the recognition of the tax gain on the net unrealized appreciation (NUA) of employer securities (received in a lump-sum distribution) held until the stock is sold or otherwise disposed of in a taxable transaction. Furthermore, the gain on NUA is taxed at long-term capital gains rates rather than as ordinary income.
What are employer securities? Employer securities are generally stock and bonds, including securities of the employer’s parent or subsidiary corporation and which are distributed in the form of a lump-sum distribution.
So what is a lump-sum distribution? A lump-sum distribution is a distribution or payment of an entire account balance from a qualified plan made within one tax year to the recipient of the balance to the credit of an employee-participant that becomes payable to the recipient under one of the following circumstances:
• On account of the participant’s death;
• After the participant attains age 59 1/2; or
• On account of the separation from service of a participant who is a common-law employee.
What is the NUA? To determine NUA, one needs to know the “cost basis” of the securities. The cost basis is the value of the securities when they were contributed to or purchased by the plan. The deferred gain, the NUA, is the difference between the fair market value of the employer securities on date of distribution and the cost basis.
Let’s look at a simple example. Assume that an employee invested $10,000 in his employer’s 401(k) plan and invested in employer stock. When the employee retires or leaves for another job and requests for a distribution from the former employer’s 401(k) plan when the securities are worth $100,000, the employee has NUA of $90,000. Rather than rolling the entire $100,000 into an IRA and deferring the recognition of income of $100,000, the employee could elect to be taxed at ordinary rates on the $10,000 cost basis and defer the recognition of the $90,000 NUA and placing those securities in a taxable brokerage account.
This special tax treatment of NUA is lost if the employee were to roll over appreciated employer securities into an IRA. This is an excellent example as to why it is prudent to work with an experienced tax professional before important financial decisions are made so that any available tax-savings strategies can be implemented. For those taxpayers who like to use TurboTax or other tax preparation software, this is one of the hidden costs of doing your own taxes.
As with any tax-planning opportunity, an analysis of the tax consequences of each alternative needs to be considered. In other words, there is no one “right” solution. Taking advantage of the special taxation of NUA of employer stock may make the most sense where employer securities have greatly appreciated and a taxpayer’s ordinary/long-term capital gains rate differential is greatest. Other factors to consider include cost basis and the 10 percent early-withdrawal penalty tax exposure. Another alternative may be to roll the stock into a traditional IRA that is converted into a Roth IRA. While converting a regular IRA into a Roth IRA increases the taxes due, it may be possible to mitigate that tax liability by making a charitable contribution of appreciated securities in the year of the conversion so that the tax savings from the charitable contribution offset all or most of the taxes resulting from the Roth conversion.
Note: Because each individual has unique factors needs that need to be examined when determining that individual’s tax situation, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your personal tax situation. You can also schedule a free consultation at Click Here. To learn more about various tax and business services, visit Tax Preparation Services and Small Business Accounting Services
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