Conventional wisdom dictates that, when leaving a job, you should generally roll over the balance of your employer-sponsored qualified retirement plan account into an IRA. Doing so gives you control over those funds and allows you to continue benefiting from tax-deferred earnings until you begin taking withdrawals. However, in some cases, conventional wisdom is worth challenging.
If your qualified retirement plan account holds appreciated stock of the employer-sponsor (company stock), and you receive a lump-sum distribution upon leaving your job, you may be better off:
You should generally roll over the rest of the distribution into an IRA, which you can do tax-free.
As long as the distributed company stock is all or part of a qualifying lump-sum distribution, only the amount of the plan's cost for the shares — generally defined as the stock's fair market value (FMV) when the plan acquired it — will be taxed currently. (See "What Counts as a Lump-Sum Distribution?" below.) If the shares have substantially appreciated while in your account, the plan's cost could be a relatively small percentage of the current value. However, that amount won't necessarily be insignificant.
Also, in the event you're under age 55 when you leave your job, the 10% early distribution penalty tax will generally apply to distributions from your account that aren't rolled over into an IRA. But in the context of distributed company stock, the penalty tax will apply only to the plan's cost in the shares, not the shares' full FMV.
When company stock is distributed as all or part of a lump-sum distribution and put into a taxable brokerage account, the plan's cost for the shares will be taxed at your regular federal income tax rate, which can be as high as 37%. But there are several offsetting tax advantages to the strategy.
First, when those distributed shares are held in a taxable brokerage account, gains up to the amount of the net unrealized appreciation (NUA) automatically qualify for the lower long-term capital gains tax rates. The NUA is the difference between the FMV of the company stock on the distribution date and the plan's cost for the shares.
Second, capital gains tax on the NUA is deferred until you sell the company stock held in the taxable brokerage account. The maximum federal income tax rate on long-term capital gains is 20%, but most people pay 15%. You may also owe the 3.8% net investment income tax (NIIT) and state income tax, if applicable.
Third, any post-distribution appreciation that occurs after the company stock is put into your taxable brokerage account will also qualify for lower long-term capital gains tax rates if you hold the shares for more than 12 months. Your holding period begins on the day after the plan delivers the stock to the transfer agent with instructions to place it in your taxable brokerage account.
Finally, if you die while still owning the company stock in your taxable brokerage account, current tax law gives your heirs a "step-up" in basis for any appreciation that occurs while the shares were in the taxable brokerage account. (Ask your tax advisor for a full explanation of what this means.) However, your heirs will owe federal income tax at long-term capital gains rates on the NUA when they eventually sell the inherited shares.
Let's say, at age 50, you leave a job with an employer that sponsors only a traditional 401(k) plan. In a single transaction, you receive a lump-sum distribution from your 401(k) account that consists of $200,000 in cash and company stock with a current FMV of $100,000. The plan's cost for the stock is $10,000. So, the company shares have $90,000 of NUA ($100,000 minus $10,000).
If you roll over the cash into an IRA and put all the company stock into a taxable brokerage account, you'll owe federal income tax on the plan's $10,000 cost for the shares. You'll also owe the 10% early distribution penalty tax on the $10,000, because you're under age 55 and don't qualify for any of the available exceptions. The distributed company stock held in your taxable brokerage account now has a tax basis of $10,000.
Assuming you're in the 24% federal income tax bracket and don't owe the 3.8% NIIT, the tax obligation from not rolling over the company stock into an IRA is $3,400 — $10,000 times (24% plus 10%). But consider the advantages. You can defer tax on the $90,000 of NUA until you sell the shares, and when you do sell, you'll pay lower long-term capital gains tax rates. Also, as long as you hold the stock for more than 12 months, you'll pay lower long-term capital gains tax rates on any appreciation that occurs while the shares are in the taxable brokerage account. Plus, your heirs may benefit from the step-up in basis should they end up inheriting and selling the company stock after your death.
But let's say that doesn't happen. Instead, while still very much alive, you eventually sell the company shares for $85,000. Your taxable gain would be $75,000 ($85,000 minus the $10,000 basis in the shares), which is less than the $90,000 of NUA that existed when the stock was distributed to you. So, your taxable gain would be limited to $75,000 (the lesser of the gain on sale or the NUA), which would be taxed at lower long-term capital gains tax rates.
If you receive company stock outside of a full or partial lump-sum distribution, and you put the shares into a taxable brokerage account instead of rolling them over into an IRA, the current FMV of the stock will generally be taxed at your higher ordinary income rate. However, if you hold the shares for more than 12 months, any subsequent appreciation on the company stock will qualify for lower long-term capital gains tax rates.
Important: There's an exception to this tax treatment if your former employer's plan account held some company stock that was paid for with nondeductible employee contributions. In that case, any NUA attributable to that stock isn't taxed until you sell the shares. Gains up to the NUA amount will automatically qualify for lower long-term capital gains tax rates. And any post-distribution appreciation in the stock's value will qualify for lower long-term capital gains tax rates if the shares are held in the taxable brokerage account for more than 12 months.
If you roll over company stock from a former employer's plan account into an IRA, no income tax will be due until you make a withdrawal. However, all the NUA and any later appreciation on those shares will eventually be taxed at higher ordinary income rates.
And that's the point of this strategy: You may get better long-term tax results when company stock received as all or part of a lump-sum distribution isn't rolled over into an IRA but instead goes into a taxable brokerage account. If interested, contact your tax advisor for further information and guidance.
For federal tax purposes, a lump-sum distribution is one or several distributions that result in an account holder receiving the entire balance from the same plan type within a single calendar year. Multiple payments are permitted as long as they're all received in the same year. To meet the entire-balance requirement, the following three aggregation rules apply:
To qualify, a distribution must occur because of your leaving an employer for any reason (otherwise known as separation of service), reaching age 59½ or dying. If you're 59½ or older, you can receive a lump-sum distribution without separating from service if the employer's plan permits it.
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