Don't Rollover That 401(k) Just Yet By Glenn At Isnare.com Ezine Articles

With the onslaught of impending baby boomer retirements, advice regarding distributions from employer-sponsored retirement plans abound. While it is generally good advice to roll-over qualified employer retirement plan assets to an IRA, that may not be good advise for anyone whose 401(k) plan contains employer stock with "net unrealized appreciation (NUA)."

NUA is the difference between the stock's current market value and average cost of the stock in the plan.

If this stock is transferred from an employer-sponsored plan to an IRA, the transfer is tax free, but any subsequent distributions from the IRA are taxable as ordinary income.

If, on the other hand, a transfer is made to a regular brokerage account, only the cost basis of the stock is immediately subject to income taxation. The remaining value, or NUA, is subject to long-term capital gains treatment.

For example, let's say Peter is 55 and taking early retirement from his company. He has $750,000 in his 401(k) plan, of which $350,000 consists of his company's stock. The company stock has a cost basis of $50,000 and the remainder of the stock value ($300,000) is appreciation or NUA.

Peter's first option is to roll the entire $750,000 into an IRA, let it grow tax-deferred and, then, start taking required minimum distributions at age 70½. The distributions from the IRA would be fully taxable as ordinary income.

Peter's second option is to keep the company stock ($350,000) in his 401(k) and roll-over the rest of his 401(k) money ($400,000) into an IRA. Peter could then transfer the company stock ($350,000) from his 401(k) plan into a regular brokerage account. This triggers ordinary income taxes on his cost basis for the company stock ($50,000), but the remaining $300,000 isn’t taxed until he sells it.

If he sells the company stock immediately after transferring it to a brokerage account, the $300,000 will be taxed as a long-term capital gain even though it hasn't been held in the brokerage account for a year.

If Peter does hold the company stock in the brokerage account for more than one year, then both the $300,000 and any further appreciation will be taxed as long-term capital gains.

Because Peter's company stock was transferred to a brokerage account rather than an IRA, the minimum distribution requirements for IRAs don't apply.

Finally, let's look at what happens if Peter dies before selling the stock in his brokerage account.

If Peter had rolled his entire 401(k) into an IRA, then his heirs would pay ordinary income taxes on any distributions they received. But, by splitting the 401(k) into both an IRA and a regular brokerage account, something quite different happens.

The IRA portion gets taxed as ordinary income under the normal distribution rules.

The stock in the regular brokerage account is treated differently. First, Peter's heirs will pay a long-term capital gains tax on the appreciated value of the company stock ($300,000), which is what Peter would have paid if he had sold the company stock during his lifetime. Any further appreciation in the value of the company stock from the date Peter transfers it to the brokerage account until Peter's death gets a step-up in basis for tax purposes, so Peter's heirs will not pay any tax (ordinary income or capital gains) on that appreciation.

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