Qualified Employer Securities in Retirement Plans

Sifting and Winnowing PlaqueLast month we discussed the unfavorable tax treatment afforded distributions from employer-sponsored retirement plans and IRAs: ordinary-income tax on distributions during the life of the owner and surviving beneficiaries and estate tax, if applicable, at death.

There is an important exception, however, to this harsh tax treatment that applies in some instances to distributions of employer securities (i.e., securities of the sponsoring employer that include both stocks and bonds) from qualified retirement plans and, more specifically, 401(k) and profit-sharing plans. The “net unrealized appreciation” (NUA), which is equal to the fair-market value of the securities less the plan’s basis in them, is excluded from the participant’s gross income at the time of the distribution. And when the participant sells the securities later, the gain is treated as long-term capital gain, not as ordinary income. Therefore a 15% capital-gain tax rate applies as opposed to a 35% ordinary-income tax rate—a 20% tax savings!

The “basis” that is distributed as part of the lump-sum distribution is taxed immediately as ordinary income in as much it represents the pre-tax contributions to the plan.

There are certain requirements that must be met for the favorable tax treatment to be available. The most important is that a lump-sum distribution of the participant’s entire account be made within one calendar year of the participant’s:

  1. death,
  2. separation of service, or
  3. attaining age 59½

Charitable planning opportunities

The distributed employer stock represents long-term appreciated securities. Thus, a charitable gift of such asset produces an income-tax deduction for the fair-market value and the donor avoids capital-gain tax on any of the appreciation.

Qualified employer stock can also be used to fund a charitable gift annuity or charitable remainder trust with similar favorable tax results

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