Have you joined the Great Resignation? Yes? If you quit your job with company stock in your 401(k) account, you might wonder if you have a tax-smart option for the stock. You probably do. Here’s what you need to know.
Conventional wisdom dictates that you should roll over any distribution from a company qualified retirement plan account into an IRA. That avoids an immediate income tax hit and allows you to continue to benefit from tax-deferred earnings until you take withdrawals from the IRA. However, following conventional wisdom is not always wise.
The tax consequences of keeping company stock in taxable account
Contrary to conventional wisdom, when a qualified retirement plan account, such as your 401(k), holds appreciated employer stock, you may be better off tax-wise by withdrawing the shares, paying a hopefully modest tax hit, and then holding the shares in a taxable brokerage firm account — instead of rolling them over into an IRA. Everything else received in the lump-sum distribution can, and generally should, be rolled over tax-free into an IRA.
As long as the distributed company shares are part of what qualifies as a lump-sum distribution (see the sidebar below for more details) from your qualified plan account(s), only the amount of the plan’s cost basis for the shares (generally FMV when the shares were acquired by the plan) is taxed currently.
If the shares have appreciated substantially while held in your retirement account, the cost basis could be a relatively small percentage of current value. That said, the cost basis will not necessarily be an insignificant amount.
If you are under age 55 when you quit your job, the 10% early distribution penalty tax will also generally apply, but it will only apply to the hopefully relatively modest cost basis amount as opposed to the full fair market value of the distributed shares.
The cost basis amount will be taxed at your regular federal income tax rate, which can currently be as high as 37%. But here are the offsetting tax benefits.
1. The net unrealized appreciation (NUA) when the shares are distributed and then held in a taxable account qualifies for the lower federal income tax rates on long-term capital gains. The NUA is the difference between the FMV of the company shares on the distribution date and the plan’s cost basis for the shares.
2. Even better, the capital gains tax on the NUA is deferred until you actually sell the shares. The current maximum federal income tax rate on long-term capital gains is 20%, but most folks will pay “only” 15%. You may also owe the 3.8% federal net investment income tax (NIIT) and state income tax, depending on where you live.
3. Any post-distribution appreciation, after the shares are distributed from your qualified plan account, also qualifies for lower long-term capital gain tax rates if you hold the shares for more than 12 months. Your holding period is deemed to begin on the day after the shares are delivered by the plan to the transfer agent with instructions to reissue the shares in your name. As stated above, the current maximum federal income tax rate on long-term capital gains is 20%, but most folks will pay 15%. You may also owe the 3.8% federal net investment income tax (NIIT) and state income tax, depending on where you live.
4. If you die while still owning the company shares, current law gives your heirs a federal income tax basis step-up for any post-distribution appreciation. However, your heirs will owe federal income tax at long-term capital gains rates on the NUA when the shares are eventually sold.
What are the tax consequences of rolling company stock into an IRA?
If you follow conventional wisdom and roll your distributed company shares into an IRA, no income tax will be due until you withdraw money from the IRA. However, all the NUA and any later appreciation in the value of the company shares will eventually be taxed at higher ordinary income rates.
Here’s an example
You join the Great Resignation by quitting your job at age 40. Your company only offers a 401(k) plan. In a single transaction, you receive a lump-sum distribution from your 401(k) account that consists of $200,000 of cash and company stock with a current FMV of $100,000. The cost basis of the stock is $10,000. So, you have $90,000 of NUA ($100,000 − $10,000). If you roll the $200,000 of cash into an IRA and keep all the stock in a taxable brokerage firm account, you’ll only owe federal income tax on the $10,000 of stock basis. You’ll also owe the 10% early distribution penalty tax because you’re not age 50 or older.
If you’re in the 24% federal income tax bracket and don’t owe the 3.8% NIIT, the federal income tax hit is $3,400 [$10,000 x (24% + 10%)]. The advantages: (1) you can defer tax on the $90,000 of NUA until you actually sell the stock and pay lower long-term capital gains rates when you do and (2) you’ll pay lower long-term capital gains rates on any additional appreciation as long as you hold the stock in your taxable account for over one year.
Warning: If you don’t receive the company stock as part of a lump-sum distribution, and you keep the distributed shares in a taxable account (instead of rolling them over into an IRA), the current FMV of the shares will be generally be taxed at higher ordinary income rates. Any subsequent appreciation in the value of the shares will qualify for lower long-term capital gains tax rates if you hold the shares for over a year.
The bottom line
The favorable federal income tax treatment illustrated in the preceding example only applies to company shares that you receive as part of a lump-sum distribution from a qualified employer retirement plan, such as a 401(k) plan. See the sidebar for what counts as a lump-sum distribution.
The point is: you might get much better tax results over the long haul if you don’t roll over company shares received as part of a lump-sum distribution. If big bucks are in play, consult your tax adviser before deciding what to do.
Sidebar: What counts as a lump-sum distribution?
Good question. A lump-sum distribution (LSD) is a distribution, or several distributions, that result in you, the employee, receiving your entire balance from a qualified pension plan, profit-sharing plan, or stock bonus plan (or several such plans) within a single calendar year. For purposes of this entire-balance requirement, the following aggregation rules apply:
1. All pension plans maintained by your employer are treated as a single pension plan. This includes target-benefit and money-purchase pension plans as well as defined-benefit pension plans.
2. All profit-sharing plans, which include 401(k) plans, maintained by your employer are treated as a single profit-sharing plan.
3. All stock-bonus plans maintained by your employer are treated as a single stock-bonus plan.
Finally, for a distribution to be an LSD, it must be received due to your separation from service (leaving the company for any reason), attainment of age 59½, or death. If you’re 59½ or older, you can receive an LSD without separating from service if the plan(s) permit it.
To sum up: a distribution will qualify as an LSD if you receive in the same calendar year your entire balance from all plans of the same type in which you participate. Multiple payments are permitted as long as you receive them all in the same year. For example, if you receive your entire balance from all company profit-sharing plans in 2022, those payouts qualify as an LSD even if you don’t receive your entire balance from the company pension plan until 2023.
Key point: In the most common situation, where you only participate in a 401(k) plan and receive your entire account balance in one year, it’s an LSD.