A Tax-Advantaged Way to Distribute Employer Stock From Retirement Plans

Clients retiring from large public companies may have significant amounts of their employer's stock as an asset in their retirement plans. For long-term employees, this stock may have enjoyed significant appreciation from the date of contribution. Provided the employer's retirement plan is a qualified plan under §401(a), such as pension, profit-sharing, 401(k), or stock-bonus plans, and the client takes a lump-sum distribution of the full balance due, the net unrealized appreciation distribution strategy may be appropriate.

This special tax treatment allows for capital gains treatment of any embedded appreciation, rather than having it taxed as ordinary income. If a few basic requirements are met, your client would be able to distribute the shares of stock in-kind from the retirement plan to a taxable brokerage account and pay ordinary income taxes on the stock's original tax basis. The tax basis is the value of the shares when they are deposited into the plan. This basis would be taxed at the client's marginal income rate in the year of distribution. The embedded appreciation in those shares (the fair market value as of the date of distribution less the tax basis), however, would be considered long-term capital gains. The gain from this approach would not be taxed until the shares are sold, which could be as soon as the day after distribution.

Most large public companies (and some large privately held companies) that allow contributions of their own stock to their retirement plans do track the original basis by share, or at least by an average cost per share, so the basis can be determined.

Any gains or losses that accrue to the shares post-distribution will follow the normal capital gain/loss rules. Gains or losses realized within 12 months of the distribution date (other than the gains embedded in the shares upon distribution) will be treated as short-term gains or losses.

A key requirement here is that the distribution must be considered a lump-sum distribution. All balances to the credit of the participant from all like plans of the same employer must be distributed in the same calendar year. This means, for instance, that if the employer has two different profit-sharing plans, the full balance of both plans must be distributed in the same year.

Note that many employer plans fund the prior year's contribution as late as October the following year. If the employee takes a partial or full distribution before this final funding, he or she will not have taken the full credit due and thus invalidate the lump-sum nature of the distribution. You must work closely with your client's plan services department to verify that no additional funds will accrue to your client before a lump-sum distribution is taken.

Here's an example of how the NUA treatment works:

Your client has 2,500 shares of his employer's stock currently worth $100 per share in his 401(k) plan. The employer determines that the original basis of the stock, whether tracked by specific shares or average cost per share, is $15 per share. The client's stock is worth $250,000 with a tax basis of $37,500. (These figures actually aren't all that unusual for employees who have spent 20 years or more with the same company or its predecessors.)

If all the requirements are met, your client can distribute the full $250,000 of stock from the plan in-kind to a taxable account and pay ordinary income taxes on just the $37,500 of basis in the shares in the year of distribution. The remaining $212,500 of appreciation will not be taxed until he chooses to sell the stock, and then it will be taxed at long-term capital gains rates of 15% to 20% instead of ordinary income rates.

A client in a very low tax bracket post-retirement may even be able to enjoy a 0% long-term capital gains rate if he sells the stock slowly. This long-term capital gain treatment is available even if he chooses to sell the stock the day following distribution. Any appreciation post-distribution could also enjoy the lower long-term capital gains rates if sales were postponed to one year post-distribution. For clients who believe their employer's stock is a good long-term investment, or who want to reduce the position slowly, the NUA treatment is very tax efficient.

Another planning situation where NUA treatment would be useful is when a client is over 55, but not yet 59 1/2, and retiring (separating from service). If he rolled the entire balance into his IRA, he would be subject to the 10% early withdrawal penalty until age 59 1/2. By distributing the employer stock to a taxable account, he has access to funds in the intervening years.

Compare this method to liquidating the stock while it is still in the plan and rolling over the entire balance in cash to an IRA. The full $250,000, as well as any further growth, would be taxed as ordinary income when distributed from the IRA. The tax bill for this scenario could be significantly higher considering marginal tax rates as high as 39.5% plus the Medicare surtax of 3.8% on investment income.

In sum, here are the special rules that apply:

The distribution must be from a qualified plan under §401(a) of the tax code. IRAs and 403b plans will not qualify. In some cases, multiple plans must be aggregated to ensure that the entire balance to the credit of the employee has been distributed. For example, all profit-sharing plans of the same employer are treated as one plan. All stock-bonus plans of the same employer are treated as one plan. The employee must take a lump-sum distribution from all plans of the same type.

The distribution must qualify as a lump-sum distribution. This means that the entire balance from all like plans of the same employer must be distributed in a single tax year and be due to death, reaching age 59 1/2 or separation from service. Just because the entire balance must be distributed from the plan does not mean that the entire plan balance must be distributed outright. The plan, for example, could make three simultaneous distributions of the entire balance: employer stock to a taxable account, pre-tax funds to an IRA and after-tax funds to a Roth IRA.

The original basis of the shares of employer stock must be available. Most employers track this for their employees. The stock does not have to be publicly traded.

When, as in this example, there is significant appreciation in employer stock, planners should evaluate whether this tax treatment is advantageous for clients. In the case of a client's death, it is critically important to inform the surviving spouse or heirs of this possibility before a full distribution is made. Once done, it can't be undone.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.