Question: I will be receiving a distribution from my employer’s retirement plan consisting of cash and employer stock. Am I better off paying tax on the employer stock or rolling over the entire distribution to an IRA?
Answer: Employees receiving distributions from qualified retirement plans usually elect to roll over plan distributions to IRAs to continue the deferral of income tax on the funds received. The Internal Revenue Code requires minimum distributions from IRAs to commence shortly after the IRA owner attains age 70 ½. The rollover option provides an effective long-term tax deferral strategy for recipients of plan distributions who are not in immediate need of retirement income.
As a participant in a qualified plan that holds stock of the sponsoring employer, you have another viable option. The net unrealized appreciation (“NUA”) in the employer stock is not subject to income tax at the time the plan distribution is made to you; only your basis in the stock will be subject to income tax at the time of the distribution. For this purpose, the NUA in the employer stock you receive is the excess of the fair market value of the stock at the time it is distributed to you over your basis in the stock. Therefore, if you receive and hold the employer stock distributed to you, only your basis in the stock will be taxed upon the distribution; the appreciation in the securities will not be subject to tax when you receive the distribution.
While NUA is not taxed at the time distributed, NUA will be taxed when the stock is subsequently disposed of in a taxable transaction. Regardless of how long you hold your employer’s stock, the NUA will be taxed as a long-term capital gain. The receipt of the employer stock thereby offers two advantages; the deferral of income tax on the NUA and taxation at capital gains tax rates on the gain from the eventual stock sale. If you do not dispose of the employer stock prior to your death, the NUA may never be subject to income tax.
Consider the alternative where the employer stock is rolled over to an IRA. In this case, no tax is imposed at the time the distribution is received by you. The funds in the IRA can continue to generate income on a tax-deferred basis until IRA distributions are required to begin. However, all IRA distributions are subject to tax at ordinary income tax rates. Therefore, the benefits of the indefinite deferral of NUA and the ultimate taxation of NUA at capital gains tax rates will not be realized once the employer stock is rolled over to an IRA.
There is no one correct answer to your question. The optimal solution can only be determined after you and your tax advisor appropriately analyze all of the tax aspects of the distribution alternatives. Among the factors to consider are your age at the time you receive the distribution, the amount of the appreciation in the employer securities and whether you intend to sell the stock and utilize the proceeds. The closer you are to the minimum distribution age, the more beneficial it may be to retain the stock and defer taxes on the NUA. If on the other hand, you are many years away from the minimum distribution age, the additional years of tax-deferred growth may make an IRA rollover preferable. A larger amount of NUA also favors holding the employer stock and not rolling the distribution over to an IRA while a smaller amount of NUA would favor an IRA rollover. Finally, the absence of a current intention to sell the stock and utilize the proceeds favor an IRA rollover.
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