How to Realize the Unrealized Combining two tax strategies, lump sum stock distributions with charitable planning can be a powerhouse tax savings plan. This article summarizes an underutilized strategy for reducing income taxes on company stock distributed from a qualified retirement plan. Also, the article covers the use of a charitable trust to further reduce income taxes and avoid capital gains tax entirely. Certain rules apply to appreciated employer stock included in a lump-sum distribution. The gain on the securities, while they are held by the qualified retirement plan (the net unrealized appreciation (NUA)), is not subject to tax until the taxpayer elects to have the NUA included in income at the time of distribution. If the election is not made at the time of distribution, the gain is recognized when the securities are sold. Since October 2002 the S & P 500 Index has had an annualized return of over 15% through the 3 rd quarter of 2007. Workers at large public companies have been accumulating shares of their employers' stock by purchasing shares in qualified plans and the value of these shares are generally up significantly. Company stock represented about 15.4 percent, or $305 billion, of all 401(k) assets as of 2004, the latest data available from research firm Cerulli Associates. It is not unusual for clients to have sizeable 401(k) balances that now include a large block of company stock with significant unrealized appreciation. Employees who are changing jobs or near retirement age are faced with what to do with their 401(k) balances. Options include continuing to own company stock in the qualified plan; take a lump-sum distribution; or rollover the stock to an IRA. Lump Sum Distributions For favorable tax rules to apply the the lump sum distribution must be made on account of the employee's death, attainment of age 59 1/2, separation from service (except self-employed individuals) or disability (self-employed only). A lump-sum distribution can be made from a profit sharing plan if the employee has attained 59 1/2 even though termination from employment has not occurred; see Letter Rulings 9721036, 8810088 and 8805025. A distribution will not qualify as a lump-sum distribution unless the employee was a plan participant for at least five of the employee's tax years prior to the distribution. The IRS has ruled that plan participants who have their entire account balances transferred directly from an old plan to a new plan may include
years of participation in both plans to satisfy the five-year participation requirement. Special rules apply to appreciated stock of the employer included in a lump-sum distribution. These rules apply to employer securities distributed from an ESOP or any other type of qualified retirement plan. The gain on the securities while held by the qualified retirement plan (the NUA) is not subject to tax until the securities are sold by the recipient, at which time the gain is eligible for capital gain treatment; see Sec. 402(e)(4). The basis of the securities (the value when contributed to the plan) is includible in income on distribution. If the value of the securities at the time of the distribution is less than their basis, the total value of the securities is taxable in accordance with the general rules applicable to lump-sum distributions. This may include 10-year averaging for a taxpayer born on or before January 1, 1936. If a distribution is taken from a qualified plan before age 55, there will be a 10% early withdrawal penalty, but only on its cost basis. In other words, if an employee receives a distribution from a qualified retirement plan after separation from service, during or after the calendar year in which the employee attains age 55, the penalty tax will not apply; see Sec. 72(t)(2)(A)(v). "Separation from service and "termination of employment" are synonymous. Separation from service does not occur when the employee continues on the same job for a different employer as a result of a corporate transaction (e.g., merger or sale). This is known as the "same desk" rule. Separation of service occurs only on death, retirement, resignation or discharge. The cost basis of the stock coming out of the plan will not receive a stepup in basis to the market value on the distribution date when sold (Rev. Rul. 69-297). Advantages of taking in-kind distribution of employer securities include: Paying income tax only on cost basis, not on NUA. Even if sold shortly after distribution the gain would be considered a longterm capital gain, taxed at 15%. Clients can make gifts to a spouse to fulfill the unified credit amount. The shares can be given to others as part of an estate gift-giving plan.
Not rolling over the stock into an IRA will reduce required minimum distributions consequently lowering income tax. Having immediate access to a potentially enormous windfall. Re-allocate stock proceeds into other investments after taxes. Donate shares to a Charitable Remainder Trust. As an alternative, a client could roll the stock into an IRA. The results of this action would include: All distributions will be taxed as ordinary income, and what is left will be included in the client's estate. Rolling the stock into an IRA will increase required minimum distributions, thus raising the income tax due. Example: In mid 2007, K decided to retire at age 63, after a 25-year career with a major software company. K's 401(k) balance had swelled to over $3 million, due to the sharp increase in the value of company stock held in the qualified plan over the last several years. K expresses his interest in diversifying his portfolio while minimizing taxes and has charitable intentions. K's cost basis is $200,000 on stock worth $2 million and his former employer allows in-kind stock distributions. K has several options. He could keep everything in his 401(k) plan; this, however, would not address his portfolio diversification concerns. If K rolls over the company stock to an IRA, there is no immediate tax consequence, but capital gain property has now been converted to ordinary income property. Distributions from an IRA are taxed at ordinary rates. K's need for diversification can be solved, but the rollover does not address income tax minimization. If K takes an in-kind distribution of all shares, ordinary income taxes will be paid on the cost basis (approximately $70,000, assuming the highest Federal bracket). K can elect to have the NUA included in income at the time the distribution is received and be subject to the long-term capital gains rate. This election is made on K's return for the year in which the distribution was received. The potential tax savings are enormous.
The remainder of the 401(k) plan assets should be rolled over to an IRA in the same tax year as the lump sum stock distribution completely draining the account. For lump sum stock distribution treatment to apply the entire 401(k) must be rolled over or withdrawn. Also K should be advised not to sell the stock in the 401(k) before withdrawal which would defeat the favorable tax treatment on withdrawal. If K did not immediately sell the stock after distribution, K could donate the shares to a charitable remainder trust (CRT) thus avoiding a capital gain tax of $270,000 ($1,800,000 * 15%). In this example the NUA is $1,800,000. A CRT is an entity that supports a charity or charities. The Internal Revenue issued a Private Letter Ruling (PLR 199919039) and ruled favorably on the above-mentioned strategy. The PLR only applies to the taxpayer receiving the ruling; note no contrary opinions have been issued by the IRS in over 8 years since the PLR. The IRS seems amicable to the strategy. Using the CRT minimizes taxes and meets K s need for portfolio diversification and charitable intentions. Assume K takes a $2M lump sum stock distribution, pays tax only on the cost basis of the shares and contributes the shares to a CRT. Once the shares are inside the CRT the stock can be sold tax free and the portfolio can be diversified. Once the trust is established K can name income beneficiaries, in this case him and his spouse. The trust can be structured to pay lifetime benefits to the either Mr. or Mrs. K as long as one is alive. The payments can be structured as a fixed amount or a variable amount based on trust design with a minimum payout of 5%. For illustration purposes assume Mr. K elects to fund a $2,000,000 Charitable Remainder Annuity Trust (CRAT) with a payout of 6% for the joint lives of him and his wife. Using the October AFR of 5.2%, ages 63 and 62 with quarterly distributions, the K s will receive a charitable trust distribution of $ 120,000 a year for their lives. They will avoid paying capital gains tax on the $ 1,800,000 and will receive a current year s income tax deduction of $ 384,732*. While this stock contribution is limited to offsetting up to 30% of their Adjusted Gross Income in any given year, what they can not use in the year of the gift they can carry forward for five additional years. This will help to offset the tax on the $ 200,000 of 401(k) stock distributed at cost as well as tax due on future trust distributions. In establishing the CRAT the K s wanted to be able to create an ongoing charitable legacy that their children could participate in. They elected to name a donor advised fund as the charity to receive the trust proceeds upon their death.
Their children are named as the Donor Advisors; they will direct the fund account and determine what charities will receive grants in the future. So by taking a lump sum distribution from the 401(k), electing to include the NUA at the time of the distribution and funding a CRAT naming a donor advised fund as the charity the K s have: Minimized the taxes on the distribution, owing income tax only the cost of the corporate stock Funded a 6% CRAT that will pay them $ 120,000 a year for their lives. Received an income tax deduction of $ 384,732 that can be used in the year of the gift and carried forward for five years. Avoided capital gains tax on the sale of $ 1,800,000 of stock thereby not diminishing the investment portfolio. Enabled the trustee to create a well diversified investment portfolio to adequately meet the annuity payout. Established a charitable legacy that their children can participate in for years. The CRT portfolio can be designed in a tax efficient manor to minimize the taxability of the distributions to the Ks. Also, the portfolio can be diversified and will not be subject to the volatility of an enormous single stock position. Retirement plan distributions rules are amazingly complex. Before advising a client, advisors need to know the kinds of distributions the plan allows. An advisor should review the summary plan document to determine what options are available. Most companies allow lump-sum distributions, but not all allow stock distributions. The owner s beneficiaries of qualified retirement plans need to be aware of the NUA rules in case of the owner s death. In determining what strategy makes sense, certain issues must be considered. Is the NUA big enough? Can the client afford to pay the taxes right away? Is the client eligible for 10-year averaging? Is portfolio diversification an issue? Significant stock option holdings should be considered. A partial distribution may be an option, with the remainder rolled over to an IRA. Further, the issue of portfolio diversification, asset allocation, asset location and taxes will have to be addressed. Last but certainly not least the client s behavioral and emotional needs and issues will have to be accommodated.
About the Authors Dean A. Mioli, CPA/PFS, CFP, CLU is a Senior Investment Analyst specializing in portfolio analysis and design for the SEI Advisor Network. Contact Information dmioli@seic.com, 610-676-3816 Barbara Rushing, CFP, CLU, ChFC is a Personal Trust Services Product Manager for SEI Private Trust Company. Contact Information brushing@seic.com,610-676-1094 * Based on Cresendo Interactive Inc. Software Version 2007.2 About the SEI Advisor Network SEI Advisor Network provides independent advisors with outsourced wealth management platforms including comprehensive trust services that are designed to meet the demands of a new generation of wealthy clients. In an evolving wealth management industry, the Network offers an end-to-end process for successfully transforming their clients' businesses in every critical area, including marketing, practice management, investment strategy and client relationship platforms. The SEI Advisor Network is a strategic business unit of SEI Investments Company. For more information, visit www.seiadvisornetwork.com. Neither SEI nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein: and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.