2 Good Reasons to Consider an 'In-Kind' Distribution

In-kind distributions--meaning that an investor receives a payout of investment securities from an entity instead of cash--are more common than you might know, especially among very large, institutional investors.

Companies that pay out dividends may choose to issue in-kind distributions, paying out additional shares of stock rather than cash. Exchange-traded funds also may pay off departing shareholders by conducting "in-kind" transactions. When a large ETF investor, called an authorized participant, wants to sell its shares, the ETF can give the institution its money back in the form of securities held in the portfolio. In this way, the ETF can flush out highly appreciated securities in its portfolios (that is, those with a low cost basis), helping to improve the ETF's tax efficiency.

But in-kind distributions aren't just limited to institutions. Taking a distribution in the form of securities rather than cash may make sense for individual investors, too, especially from the standpoint of reducing taxes. If you inherit securities from another person, you'll usually have no choice but to receive those securities "in kind," though once you've inherited those investments you're free to make changes as you see fit.

Here are two of the key instances to consider a voluntary in-kind distribution rather than taking the cash instead.

You Need to Take RMDs in a Depressed Market
If you find yourself with IRA holdings that are depressed in value and you need to take required minimum distributions, you can make lemonade by taking your RMDs in kind--that is, meeting your RMD requirements by receiving the actual securities rather than cash and moving those securities into a taxable brokerage account. You can't circumvent the income taxes on the RMD, of course. But by taking the securities out of your IRA when you believe their value is at a low ebb, you'll pay ordinary income taxes at a relatively low level. And when you move those same securities to a taxable brokerage account, any appreciation beyond today's relatively low prices will be taxed at the capital gains rate rather than your ordinary income tax rate.

Say, for example, a 75-year-old in the 30% tax bracket takes an in-kind RMD of a stock position worth $50,000 at the time of the distribution. He'd owe $15,000 in taxes on the distribution--ideally paying the taxes with separate assets--and his cost basis on those securities in the taxable account would be $50,000. If the stock appreciates to $80,000 during the next three years and he decides to sell, his tax bill would be $4,500--his $30,000 in appreciation multiplied by the 15% capital gains rate.

By contrast, say that same retiree opts to hang on to the depressed stock within the IRA and takes a distribution of $50,000 in cash from a money market fund instead. His tax bill on the RMD would be the same--$15,000. But if he were to eventually sell the once-depressed stock from the IRA at a market value of $80,000, his tax bill on that distribution would be $24,000.

Because the market has been on a tear, moving securities to a taxable account may not come in handy right now. But it's one to keep in your back pocket if a holding slumps but you still believe in its fundamentals.

You Hold Highly Appreciated Stock in a Company Retirement Plan
Last week I mentioned that people holding company stock that has appreciated a lot since they acquired it have good reason to leave the money in their former employer's 401(k) plan rather than rolling it over into an IRA. The reason is that by forgoing the rollover, you can take an in-kind distribution of company stock from the 401(k), which in turn enables you to take advantage of the tax rules regarding net unrealized appreciation, or NUA. When you take the in-kind distribution and move the money into a taxable brokerage account, you'll owe ordinary income tax on your cost basis in the stock, plus a 10% early distribution penalty if you're under age 59 1/2. But you'll only owe capital gains taxes, which are lower, when you eventually sell the shares from your taxable account. That's often more advantageous than rolling the money into an IRA, where all distributions would be taxed at your ordinary income tax rate.

For example, let's say a 62-year-old recent retiree had $800,000 in company stock and a cost basis of $100,000; she's in the 25% tax bracket and has accumulated the stock with a combination of pretax 401(k) contributions and employer matching contributions. The appreciation above her cost basis, $700,000 is NUA. If she were to roll over that money into an IRA, she would owe ordinary income taxes on her distributions during retirement, nicking roughly $200,000 ($800,000 taxed at her 25% rate) from her account's value, assuming no appreciation in the shares and no change in her tax rate.

By contrast, using the NUA rules could allow her to realize significant savings. At the time of the in-kind distribution she would owe $25,000 in taxes (25% of her $100,000 cost basis). But when she eventually sells her shares from a taxable account, she would pay long-term capital gains taxes on her NUA of $700,000, bringing her total tax cost to $130,000--the $25,000 on her cost basis plus $105,000 in long-term capital gains taxes on her $700,000 in NUA. She would also owe long-term capital gains taxes on any appreciation after she transfers the shares from her 401(k) into her brokerage account.

Of course, there may be good countervailing reasons to roll over the money into an IRA, too. The big one is that having a sizable stake in company stock can leave your portfolio underdiversified, and that can outweigh the tax benefits of opting for NUA treatment. This calculator can help you determine the attractiveness of the NUA strategy given your specific variables, though it doesn't take into account investment considerations and diversification.

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