When you retire or change jobs, it is generally a good idea to roll over your employer-sponsored qualified retirement plan balances into a traditional IRA.
That way, you avoid an immediate tax hit and continue to benefit from tax-deferred earnings growth until you withdraw money from the IRA.
But that advice may change if the employer-qualified plan account holds appreciated company stock. In that case, you could be better off withdrawing the shares, paying the taxes, and holding the stock in a taxable brokerage firm account. Here is why.
The net unrealized appreciation of the shares goes untaxed until you sell them. As long as the shares are part of a lump-sum distribution from your retirement accounts, you pay current tax only on the retirement plan's cost basis in the stock. The cost basis is generally the value of the shares when they were acquired by the plan. The net unrealized appreciation is the difference between cost basis to the plan and the shares' market value on the date they are distributed to you.
If the shares have appreciated substantially, the plan's cost basis could be a relatively small percentage of the shares current market value as of the distribution date. However, the cost basis could still be significant in absolute dollars, so the tax hit may be more than a nominal amount.
In addition, if you are under 55 years of age when you leave your job, you generally have to pay the 10% federal tax penalty on premature withdrawals. That might be worth it, though, if the taxable income, which is equal to the cost basis, is small.
When the net unrealized appreciation is taxed, it automatically qualifies as a long-term capital gain eligible for favorable capital gains rates (see IRS Notice 98-24). As you know, the current maximum federal rate on long-term capital gains is only 20%, compared with a maximum 37% on ordinary income.
Additional Tax Savings
Appreciation of the shares after the distribution also qualifies for the favorable capital gains rates, provided you hold the stock for more than 12 months after receiving them from the plan.
Even More Tax Savings
If you own the stock when you die, your heirs are entitled to a federal income tax basis step-up for any post-distribution appreciation. However, when they sell the shares, the net unrealized appreciation will be taxed under the "income in respect of a decedent" rules. The good news is the unrealized appreciation will be taxed at the favorable rates for long-term capital gains. (see IRS Revenue Ruling 75-125)
In contrast, if you roll the employer stock over tax free into an IRA, you pay tax on the stock gains only when the shares are sold and you take withdrawals from the IRA. The net unrealized appreciation and post-distribution appreciation will count as ordinary income, so you or your heirs will owe as much as 37% in taxes in 2019 rather than the favorable capital gains tax (and 2018)
Before following this tax-saving strategy, be sure the shares qualify and are part of a lump-sum distribution. The rules are tricky, so consult with your tax advisor if you have questions or want to discuss whether this maneuver will work for you.
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