Most individuals are aware that retirement-plan benefits fare poorly under the tax code: They are subject to ordinary-income tax on distributions during the life of the owner and surviving beneficiaries as well as estate tax, if applicable, at death. In some instances the combined tax can reach more than 70% when state death taxes are factored in!
To avoid immediate taxation upon retirement or separation from service, many employees elect to roll over their benefits to an IRA. There are several advantages to doing so: avoiding income tax on the retirement benefits; having the benefits continue to grow on a tax-free basis; enabling the employee to sell securities in the IRA and diversify the portfolio without incurring income tax; and stretching the distributions from the IRA once age 70½ is reached, according to a very favorable life-expectancy schedule.
Many qualified retirement plans—and more specifically for purposes of this article, 401(k) plans—invest a portion of the contributions made on behalf of employee participants in the securities, both stocks and bonds, of the sponsoring employer. The extent of investments in employer stock varies. Prior to the Enron debacle it was quite extensive, and in many instances employees did not have much choice in the matter. Recent legislation now enables employees a much wider choice of investments, including the option of opting out of owning any employer stock. Nevertheless, substantial amounts of employer stock still reside in 401(k) plans.
The following example illustrates some possible scenarios:At retirement, Mary, 65, a long-term employee of Acme Corp., has $1,200,000 in her 401(k) plan. Her basis, or what the plan paid for the stock, is $200,000.
Scenario 1
Assume the $1,200,000 consists of investments other than Acme stock and that Mary decides to withdraw the entire account balance. Result: It’s all taxable, and she will be subject to ordinary-income tax to the tune of $480,000 (40% of $1,200,000).
Scenario 2
Mary directs Acme to roll over the $1,200,000 to her IRA. Result: It’s a tax-free rollover with no immediate income tax because all transactions within the IRA are free of income tax. Mary can make withdrawals anytime but must begin to do so when she reaches age 70½. The distributions will be subject to ordinary-income tax. At her death the balance may be subject to estate tax and her beneficiaries will continue to be taxed on their distributions at ordinary-income tax rates.
Scenario 3
Assume the $1,200,000 consists entirely of Acme stock and that Mary directs Acme to roll it over to her IRA. Result: Same as in Scenario 2 above. The one important benefit, however, is that she can sell some or all of the Acme stock without incurring any income tax and deploy the proceeds to achieve the level of diversification that she deems to be prudent within her IRA.
The Good News
Employer stock can receive very favorable tax treatment if properly planned. The special favorable treatment of employer stock in a lump-sum distribution to be continued next month… Stay tuned.
