During your working years, you've probably set aside funds in retirement accounts such as IRAs, 401(k)s or other workplace savings plans, as well as in taxable accounts. As you approach retirement, you'll need to consider how to convert those savings into an ongoing income stream that will provide adequate income throughout your retirement years.
As you consider your options, keep in mind that one of the greatest advantages of IRAs and employer-sponsored retirement plans, like 401(k)s, is that they allow you to save for retirement on a tax-deferred basis. When you retire, it's essential to consider the continued tax deferral of these retirement funds, and, if possible, the avoidance of current taxes and penalties that could eat into the amount of money you've saved.
While this article discusses 401(k) plans in particular, similar considerations apply to other employer savings plans like profit-sharing plans, thrift plans, 403(b) and 457(b) plans, and ESOPs. Traditional pension plans (also known as defined benefit plans) are subject to different rules, and are not covered here.
Know Your Distribution Options
The distribution options available to you when you retire are determined by your employer's 401(k) plan. Some plans have a wide variety of distribution options, others have only a few. The terms of your plan control, so check with your plan administrator to see which options are available to you. Your distribution options will also be spelled out in your plan's summary plan description (SPD).
You need to be aware of your distribution options for several reasons. First, your choices may result in different tax consequences for you — one choice may lead to immediate taxation or taxation at a higher rate, while another choice may allow continued tax-deferred growth of your retirement money. Second, your payout choices may determine how long your retirement plan funds last.
When dealing with retirement money, you need to be extra careful about the amount and timing of your distributions. One or more bad decisions now could have a significant impact later in your retirement. Finally, different choices may result in different payouts and tax consequences for your beneficiaries. This can be an important concern if providing for your beneficiaries and minimizing their taxes is one of your goals.
Take the Money and Run — Lump-Sum Distributions
When you retire, you can generally withdraw your 401(k) funds in a lump-sum cash payment. To do this, simply instruct your plan administrator to cut you a check. Then, you're free to do whatever you please with those funds. You can use them to meet expenses (e.g., medical bills), put them toward a large purchase (e.g., a home or car), or invest them elsewhere. While cashing out is certainly tempting, it's almost never a good retirement strategy. Taking a cash distribution can significantly reduce your retirement savings, and is generally not advisable unless you urgently need money and have no other alternatives. Not only will you miss out on the continued tax deferral of your 401(k) funds, but you'll also face an immediate tax bite.
First, you'll have to pay federal (and possibly state) income tax (at ordinary income tax rates) on the money you withdraw, except for the amount of any after-tax contributions you've made (special rules apply to Roth contributions, discussed below). If the amount is large enough, you could even be pushed into a higher tax bracket for the year. If you're under age 59½ when you retire, you'll also have to pay a 10% premature distribution penalty tax on the taxable portion of your distribution, unless you qualify for an exception. And, because your employer is required to withhold 20% of your distribution for federal taxes, the amount of cash you get may be significantly less than you expect.
Tip: One important exception from the 10% premature distribution penalty tax is for distributions you receive from your 401(k) plan after separation from service in the year you turn age 55 or later.
Caution: Lump-sum distributions from 401(k) plans involve complex tax issues, especially for individuals born before 1936. See "Special lump sum distribution tax rules," below, for additional information. If your 401(k) plan allows Roth contributions, qualified distributions of your Roth contributions and earnings will be free from federal income tax. A qualified distribution is a payment from your Roth 401(k) account that meets both of the following requirements:
- The payment is made after you turn age 59½, become disabled, or die, and
- The payment is made after the five-year period that starts with the year you make your first Roth contribution to the 401(k) plan.
Tip: If your qualified distribution includes employer securities, your basis in those securities is the fair market value of the securities at the time they're distributed. Any additional appreciation will be taxed as long-term or short-term capital gains, depending on how long you hold the securities following the distribution from the plan.
Caution: IRS regulations provide that certain distributions, like distributions of excess Roth 401(k) contributions and deemed loan distributions, can never be qualified distributions.
One of the requirements for a qualified distribution is that it must be made after a five-year period of participation. In general, the five-year period begins on the first day of the first calendar year that you make a Roth 401(k) contribution (regular or rollover) to your 401(k) plan. The five-year period ends when five consecutive taxable years have been completed.
Example(s): Nicole made her first Roth 401(k) contribution to her company's 401(k) plan in December of 2016. Nicole's five-year waiting period begins January 1, 2016, and ends December 31, 2020.
Caution: Certain contributions don't start the five-year holding period. For example, if all of your Roth contributions for a year are excess deferrals, those contributions will not start the five-year holding period. Similarly, contributions returned to you as an excess contribution (to prevent the plan from failing nondiscrimination requirements), and certain contributions returned to you from a 401(k) plan with an auto-enrollment feature will not start the five-year period.
The five-year waiting period is determined only once for a particular Roth 401(k) plan participant. For example, if you participate in your employer's plan for 10 years, retire and receive your entire Roth 401(k) account balance as a qualified distribution, and then are rehired and start contributing to the same plan again, you won't need to satisfy a new five-year waiting period.
If you make Roth 401(k) contributions to plans maintained by different employers, the five-year holding period is determined independently for each of your Roth accounts. But an important exception applies — if you make a direct rollover of Roth dollars from a prior employer's plan to your new employer's plan, the five-year holding period for the new plan will start with the year you made your first Roth contribution to the prior plan.
Caution: This special rule applies only to direct rollovers. If you receive a distribution, and then make a 60-day rollover to your new employer's 401(k) plan, the holding period from the first plan will not apply.
Example(s): Jim makes Roth contributions to Acme Corporation's 401(k) plan beginning in 2016. In 2019, Jim leaves Acme and joins Beacon Corporation, and begins making Roth contributions to Beacon's 401(k) plan. Jim will have two separate five-year holding periods — one for his Acme Roth account (which will end December 31, 2020) and another for his Beacon Roth account (which will end December 31, 2023). In 2019, Jim decides to make a direct rollover of his Acme Roth account to Beacon's 401(k) plan. Jim's holding period for his Acme Roth account will carry over to his entire Beacon Roth account, and Jim can now receive tax-free qualified distributions from the Beacon 401(k) plan beginning in 2021 (assuming Jim is 59½ by then).
If a payment does not satisfy the conditions for a qualified distribution, the portion of the payment that represents the return of your own Roth contributions will be tax free, because you've already paid income taxes on those contributions. But the portion of the payment that represents earnings on those contributions will be subject to income tax (at ordinary income tax rates), as well as a potential 10% premature distribution tax, unless an exception applies.
Tip: IRS regulations provide that each distribution from a Roth 401(k) account is deemed to consist of a pro-rata share of an employee's Roth contributions and investment earnings on those contributions.
Tip: If your nonqualified distribution includes employer securities, you may be able to elect net unrealized appreciation (NUA) treatment.
Leave the Funds in Your Employer's Plan
Another option when you retire is simply to leave the funds in your employer's 401(k) plan where they will continue to grow tax deferred. Leaving your money in your 401(k) plan may be a good idea if you're happy with the investment alternatives or distribution options offered, or you need time to explore other options.
However, you may not always have this opportunity. If your vested balance is $5,000 or less, your employer can require you to take your money out of the plan when you leave the company; however, if the account is more than $1,000 the employer will have to roll the money into an IRA in your name. (Your vested balance consists of anything you've contributed to the plan, as well as any employer contributions you have the right to receive.) Also, your employer isn't required to let you keep your funds in the plan after you reach the plan's normal retirement age (usually age 65).
Tip: If you decide to leave your funds in your employer's 401(k) plan, you may have the option of converting all or part of your non-Roth accounts to a Roth account. You'll pay federal income tax at the time of the conversion, but qualified distributions will be income tax free. Check with your plan administrator to see if this option is available to you. If you are able to leave your funds in your employer's plan, at some point you'll need to select a distribution option. As noted earlier, the options available to you depend on the specific terms of your employer's 401(k) plan. Your plan will also specify when you must begin taking distributions. Typically, some or all of the following distribution options will be available to you:
- Fixed period of time: You receive installment payments over a fixed period such as 10 or 15 years. The period of time cannot be longer than your life expectancy, or the joint and survivor life expectancy of you and your beneficiary. Payments are set in an amount calculated to deplete the account balance by the end of the specified period. Payments will typically be adjusted upward or downward if actual investment returns are different than anticipated.
- Based on a life expectancy calculation: You receive installment payments based on a specified life expectancy calculation such as a single life expectancy. The applicable life expectancy figure is determined by referring to IRS tables. This option is similar to the fixed period of time option, but the payout period used is not a specified number of years; it is based on the applicable life expectancy instead.
- Fixed amount until balance is exhausted: You receive regular payments in a fixed amount that is paid periodically until there are no funds left in the account. Some assumptions as to future investment returns is necessary to estimate the length of the payment period. The actual period may vary depending on investment results, but the amount of each payment never varies.
- Annuity: An increasing number of 401(k) plans are starting to provide annuities as a distribution option. An annuity generally provides guaranteed payments for your life (or sometimes over the joint lives of you and your spouse or other contingent annuitant). An annuity might be a good option for you if you're concerned about your ability to direct the investment of your funds yourself. An annuity also provides a fixed income that you won't outlive. However, like other fixed income investments, your benefit can be eroded by inflation. Also, an annuity is generally a poor choice for those in bad health — you run the risk of premature death, in which case your payments generally end, leaving nothing to your heirs. If you like the idea of annuitizing all or part of your 401(k) plan funds, you might get a better deal by doing so inside your 401(k) plan than you would on your own, as plans are generally eligible for lower institutional pricing.
Caution: The guaranteed payments are subject to the financial strength and claims-paying ability of the issuing insurance company.
Tip: If your plan provides an annuity option and you are married, federal law generally requires that your benefit be paid in the form of a qualified joint and survivor annuity (QJSA). The QJSA is an annuity that pays benefits to you during your lifetime, with 50% to 100% of your payment continuing after your death to your spouse if he or she survives you. Typically, the benefit you'll receive under the QJSA is smaller than the single life annuity, because payments will be made over two lifetimes instead of one. You can, with your spouse's consent, elect to receive a single life annuity instead of the QJSA. The issues involved in deciding between a QJSA and a single life annuity can be complicated. Your financial professional can help you decide which a better option is for you.
- As needed: This highly flexible arrangement permits you to withdraw from your account on a variable basis as you need the funds. You may receive a certain amount on regular payment dates for a fixed period, or you may choose to receive any amount at any time. The advantage is that you take only what you need, letting the balance of the funds continue to grow tax deferred. Some plans don't require that you take any distributions until you must start taking required minimum distributions after you reach age 70½ (or age 72 if you attain age 70½ after 2019).
Roll the Funds Over to an IRA
When you retire, you can roll over all or part of your non-Roth 401(k) funds into a traditional IRA. You can transfer the funds either to a traditional IRA that you already have, or open a new IRA to receive the funds. A rollover can be direct (your plan's trustee sends the funds directly to your IRA, or issues a check to you payable to your IRA) or indirect (your plan's trustee pays the funds to you, and then you deposit the funds into your IRA within 60 days). An indirect rollover is generally a bad idea if you want to roll over your entire distribution.
This is because, with an indirect rollover, your plan administrator will be required to withhold 20% of your taxable distribution. This means that you'll need to have additional funds available to replace the 20% withheld at the time of distribution. (You'll get credit for the 20% withheld when you file your federal income tax return the following year.)
Caution: If you do not make up the 20% with additional funds, the 20% withheld will actually be considered a taxable distribution. If you fail to complete the rollover within 60 days, the entire distribution may be treated as a taxable distribution.
A properly completed rollover (direct or indirect) is a tax-free transfer of assets, not a taxable distribution. This means that you will not be subject to income tax or early withdrawal penalties on the money. You won't pay federal or state income tax on the money until you begin taking taxable distributions from the IRA. By that time, you may be retired and in a lower income tax bracket.
Also, if you are 59½ or older when you take distributions from your IRA, you won't have to worry about premature distribution penalties. When you roll over funds from your 401(k) plan to your IRA, you are simply moving your retirement money from one tax-favored savings vehicle to another. This allows the money to continue growing tax deferred in the IRA with little or no interruption. There's no dollar limit on how much 401(k) money you can roll over to an IRA.
You can also roll over a distribution of your non-Roth 401(k) money to a Roth IRA. These rollovers are often called "conversions," because they are similar to a conversion of a traditional IRA to a Roth IRA. The taxable portion of your distribution from the 401(k) plan will be included in your income at the time of the rollover.
If you've made Roth contributions to your 401(k) plan, you can roll those contributions, and any investment earnings on them, to a Roth IRA only. Qualified distributions from your Roth IRA will be free from federal income taxes.
Caution: Your Roth 401(k) five-year holding period does not carry over to your Roth IRA. You must separately satisfy the five-year holding period for Roth IRAs. The five-year holding period generally begins on January 1 of the tax year in which you made your first contribution (regular or rollover) to any Roth IRA.
Caution: Some distributions cannot be rolled over, including required minimum distributions and certain annuity and installment payments.
Advantages of rolling your funds over to an IRA:
- You generally have more investment choices with an IRA than with an employer's 401(k) plan. You typically may move your money around to the various investments offered by your IRA trustee, and you may divide up your balance among as many of those investments as you want. By contrast, employer-sponsored plans typically give you a limited menu of investments (usually mutual funds) from which to choose.
Caution: Before investing in a mutual fund, carefully consider the investment objectives, risks, charges, and expenses of the fund.
This information can be found in the prospectus, which can be obtained from the fund. Read it carefully before investing.
- You can freely move your IRA dollars among different IRA trustees/custodians. Unlike indirect rollovers between IRAs, which are generally limited to one in any 12-month period, there is no limit on how many direct, trustee-to-trustee IRA transfers you can do in a year. This gives you flexibility to change trustees often if you are dissatisfied with investment performance or customer service. It can also allow you to have IRA accounts with more than one institution for added diversification. With an employer's plan, you cannot move the funds to a different trustee unless you leave your job and roll over the funds.
- An IRA may give you more flexibility with distributions. With an IRA, the timing and amount of distributions is generally at your discretion (until you reach age 70½ (or age 72 if you attain age 70½ after 2019) and must start taking required minimum distributions).
- If you've made Roth 401(k) contributions to your 401(k) plan, those contributions (plus any investment earnings on them) will be subject to required minimum distribution (RMD) rules after you turn 70½ (or age 72 if you attain age 70½ after 2019) or after you retire, if later (if you are more than a 5% owner of the business, RMDs must begin after age 70½ (or age 72 if you attain age 70½ after 2019)). You can avoid the RMD rules by rolling your Roth 401(k) contributions over to a Roth IRA (Roth IRAs are not subject to the lifetime RMD rules) before reaching age 70½ (or age 72 if you attain age 70½ after 2019). After age 70½ (or age 72 if you attain age 70½ after 2019) you can still roll your Roth 401(k) contributions to a Roth IRA, but an RMD will need to be withdrawn prior to the rollover.
- You can use an individual retirement annuity to effectively annuitize all or part of your 401(k) plan benefit. This can be helpful if your 401(k) plan doesn't provide an annuity option. Disadvantages of rolling your funds over to an IRA:
- If you roll over all or part of your 401(k) distribution into an IRA, neither that distribution, nor any future lump-sum distribution you receive from the 401(k) plan, will be eligible for special 10-year averaging or capital gains treatment (see below).
- Distributions from your 401(k) plan won't be subject to the 10% premature distribution penalty if you retire during the year you turn 55 or later. However, distributions from your IRA before you turn age 59½ will be subject to the penalty tax, unless an exception applies.
- Assets in employer plans that are subject to the non-alienation provisions of ERISA [for example, most 401(k) plans] receive virtually unlimited protection from creditors under federal law. Your creditors cannot attach your plan funds to satisfy any of your debts and obligations, regardless of whether you've declared bankruptcy. In contrast, traditional and Roth IRAs are generally protected under federal law only if you declare bankruptcy. Any creditor protection your IRA may receive in cases outside of bankruptcy will generally depend on the laws of your particular state. If you are concerned about asset protection, be sure to seek the assistance of a qualified professional.
- Many employer-sponsored plans have loan provisions. You cannot borrow from an IRA — you can only access the money in an IRA by taking a distribution, which may be subject to income tax and penalties.
- While IRAs typically provide more investment choices than an employer plan, there may be certain investment opportunities in your particular plan that you cannot replicate with an IRA. Further, you may be satisfied by the low-cost institutional funds available in your particular plan, and therefore you may not regard an IRA's broader array of investments as an important factor.
- You may be able to postpone required minimum distributions by leaving funds in an employer retirement plan. These distributions usually must begin by April 1 following the year you reach age 70½ (or age 72 if you attain age 70½ after 2019). However, if you work past that age and are still participating in your employer's plan, you can delay your first distribution from that plan until April 1 following the year of your retirement. (You also must own no more than 5% of the company.) This deferral exception is not available for IRAs. (Minimum distributions are not required from Roth IRAs during your lifetime.)
- You'll be responsible for investing your lump-sum dollars until you need them. Investment losses, especially in your early years of retirement, could also cause you to experience a retirement income shortfall.
Caution: All investing involves risk, including the possible loss of principal, and there can be no assurance that any investment strategy will be successful.
- Both employer retirement plans and IRAs typically involve: (1) investment-related expenses, and (2) plan or account fees. Investment-related expenses may include sales loads, commissions, the expenses of any mutual funds in which assets are invested, and investment advisory fees. Plan fees typically include plan administrative fees (e.g., recordkeeping, compliance, trustee fees) and fees for services such as access to a customer service representative. In some cases, employers pay for some or all of the plan's administrative expenses. An IRA's account fees may include, for example, administrative, account set-up, and custodial fees. Be sure to carefully consider the expenses and fees in each alternative.
- Also be sure to consider the different levels of service available under the employer's plan versus an IRA. Some employer plans, for example, provide access to investment advice, planning tools, telephone help lines, educational materials, and workshops. Similarly, IRA providers offer different levels of service, which may include full brokerage service, investment advice, distribution planning, and access to securities execution online.
Which Assets Should You Draw From First?
You may have assets in accounts that are taxable (e.g., CDs and mutual funds held outside of IRAs or other retirement plans), tax deferred [e.g., investments held in traditional IRAs and 401(k)s], and tax free [e.g., Roth IRAs and Roth 401(k)s]. Given a choice, which type of account should you withdraw from first? The answer is — it depends.
For retirees who don't care about leaving an estate to beneficiaries, the general answer is simple in theory: withdraw money from taxable accounts first, then tax-deferred accounts, and lastly, tax-free accounts. By using your tax-favored accounts last, and avoiding taxes as long as possible, you'll keep more of your retirement dollars working for you.
For retirees who intend to leave assets to beneficiaries, the analysis is more complicated. You need to coordinate your retirement planning with your estate plan. For example, if you have appreciated or rapidly appreciating assets, it may be more advantageous for you to withdraw from tax-deferred and tax-free accounts first. This is because these accounts will not receive a step up in basis at your death, as many of your other assets will.
However, this may not always be the best strategy. For example, if you intend to leave your entire estate to your spouse, it may make sense to withdraw from taxable accounts first. This is because spouses are given preferential tax treatment with regard to retirement plans. A surviving spouse can roll over retirement plan funds to his or her own IRA or retirement plan, or, in some cases, may continue the deceased spouse's plan as his or her own. The funds in the plan continue to grow tax deferred, and distributions need not begin until the spouse's own required beginning date. The bottom line is that this decision is also a complicated one.
Another factor to consider is that assets in IRAs and employer-sponsored retirement plans enjoy special protection from creditors under federal and most state laws. Federal law provides unlimited protection from creditors for your 401(k) plan assets [if your plan is covered by the Employee Retirement Income Security Act of 1974 (ERISA)]. Federal law also provides protection for up to $1,362,800 (scheduled to increase in April 2022) of your aggregate Roth and traditional IRA assets if you declare bankruptcy. [SEP IRAs, SIMPLE IRAs, and amounts rolled over to the IRA from an employer qualified plan or 403(b) plan, plus any earnings on the rollover, aren't subject to this dollar cap, and are also fully protected if you declare bankruptcy.]
The laws of your particular state may provide additional bankruptcy protection for your IRA assets, and may provide protection from the claims of your creditors even in cases outside of bankruptcy. You should check with an attorney to find out how your state treats IRAs assets. If asset protection is important to you, this could impact the order in which you take distributions from your various retirement and taxable accounts. The bottom line is that this decision is a complicated one. A financial professional can help you determine the best course based on your individual circumstances.
When You Must Start Taking Distributions — Required Minimum Distributions
Note: Required minimum distributions for defined contribution plans (other than Section 457 plans for nongovernmental tax-exempt organizations) and IRAs have generally been suspended for 2020. The waiver includes distributions for 2019 with an April 1, 2020, required beginning date that were not taken in 2019.
In practice, your choice of which assets to draw first may, to some extent, is directed by tax rules. You can't keep your money in tax-deferred retirement accounts forever. The law requires you to start taking distributions — called "required minimum distributions" or RMDs — from your 401(k) plan by your "required beginning date," whether you need the money or not. Your required beginning date for taking your first RMD is April 1 of the calendar year following the calendar year in which you reach age 70½ (or age 72 if you attain age 70½ after 2019).
However, there is one situation where your required beginning date can be later than just described. If you work past age 70½ (or age 72 if you attain age 70½ after 2019), your required beginning date can be as late as April 1 of the calendar year following the calendar year in which you retire when both of the following apply:
- Your employer's 401(k) plan allows you to delay your required beginning date in this manner
- You own 5% or less of the employer's company
Your 401(k) plan will generally calculate the RMD and distribute it to you. (If you participate in more than one employer retirement plan, your RMD will be determined separately for each plan.)
Example(s): You own more than 5% of your employer's company and you are still working at the company. Your 70th birthday was December 2, 2018. This means that you will reach age 70½ in 2019. So, normally you must take your first RMD from your retirement plan by April 1, 2020, even if you are still working for the company at that time. However, since RMDs are waived for 2020 (and assuming you didn't take the RMD for 2019 in 2019), you will not need to take an RMD (that would normally be your third RMD) until December 31, 2021.
Example(s): You have money in two plans — one with your current employer and one with a former employer. You own less than 5% of each company. Your 70th birthday was December 2, 2018, (and you will reach 70½ on June 2, 2019), but you'll keep working until you turn 73 on December 2, 2021. You can delay your first RMD from your current employer's plan until April 1, 2022 — the April 1 following the calendar year in which you retire. However, as to your former employer's plan, normally you must take your first distribution by the April 1 following the calendar year you reached age 70½ — that is, April 1, 2020. However, since RMDs are waived for 2020 (and assuming you didn't take the RMD for 2019 in 2019), you will not need to take an RMD (that would normally be your third RMD) until December 31, 2021. Regardless of your required beginning date, subsequent distributions are due on or by December 31 of each calendar year.
Caution: If you delay your first required distribution, you will have to take both your first and second required distributions in the same calendar year.
Tip: Roth 401(k) contributions are subject to the RMD rules. However, you can generally avoid these rules by rolling your Roth 401(k) funds over to a Roth IRA. It's important to take RMDs into account when contemplating how you'll withdraw money from your savings. Why? If you withdraw less than your RMD, you will pay a penalty tax equal to 50% of the amount you failed to withdraw. The good news: you can always withdraw more than your RMD amount.
Special Lump-Sum Distribution Tax Rules
In some cases, your choice of distribution options will be driven by the tax consequences. This is particularly true for lump-sum distributions. Qualifying lump-sum distributions may be eligible for three special tax rules: net unrealized appreciation (NUA), ten-year income averaging, and special capital gains treatment.
To qualify as a lump-sum distribution, both of the following conditions must be satisfied:
- It must be a distribution of your entire balance, within a single tax year, from all of your employer's qualified plans of the same type (i.e., all pension plans, all profit-sharing plans, or all stock bonus plans)
- For NUA, the distribution must be paid after you reach age 59½ as a result of your separation from service, or after your death (or, if you are self-employed, as a result of your permanent and total disability)
Net Unrealized Appreciation
When you receive a lump-sum distribution from your employer's retirement plan, the distribution is generally taxable to you at ordinary income tax rates. As discussed above, a common way of avoiding immediate taxation is to make a tax-free rollover to a traditional IRA. However, when you ultimately receive distributions from the IRA, they'll also be taxed at ordinary income tax rates. (Special rules apply to Roth and other after-tax contributions that are generally tax free when distributed.)
But if your distribution includes employer stock (or other employer securities), you may have another option — you may be able to defer paying tax on the portion of your distribution that represents net unrealized appreciation (NUA). You won't be taxed on NUA until you sell the stock. What's more, NUA will be taxed at long-term capital gains rates — typically much lower than ordinary income tax rates. This strategy can often result in significant tax savings.
Caution: If you want to take advantage of NUA tax treatment, be sure you don't roll the stock over to an IRA. That will be irrevocable, and you'll forever lose the NUA opportunity.
A distribution of employer stock consists of two parts: (1) the cost basis (i.e., the value of the stock when it was contributed to, or purchased by, your plan), and (2) any increase in value over the cost basis until the date the stock is distributed to you. This increase in value over basis, fixed at the time the stock is distributed in-kind to you, is the NUA. For example, assume you retire and receive a distribution of employer stock worth $500,000 from your 401(k) plan, and that the cost basis in the stock is $50,000. The $450,000 gain is NUA.
At the time you receive a lump-sum distribution that includes employer stock, you'll pay ordinary income tax only on the cost basis in the employer securities. You won't pay any tax on NUA until you sell the securities. At that time, NUA is taxed at long-term capital gain rates, no matter how long you've held the securities outside of the plan (even if only for a single day). Any appreciation at the time of sale in excess of NUA is taxed as either short-term or long-term capital gain, depending on how long you've held the stock outside the plan.
Using the example above, you would pay ordinary income tax on $50,000 (the cost basis), when you receive your distribution. (You may also be subject to a 10% early distribution penalty if you're not age 55 or totally disabled.) Let's say you sell the stock after ten years, when it's worth $750,000. At that time, you'll pay long-term capital gains tax on NUA ($450,000). You'll also pay long-term capital gains tax on the additional appreciation ($250,000), since you held the stock for more than one year. Since you've already paid tax on the $50,000 cost basis, you won't pay tax on that amount again when you sell the stock.
If your distribution includes cash in addition to the stock, you can either roll the cash over to an IRA or take it as a taxable distribution. And, you don't have to use the NUA strategy for all of your employer stock — you can roll a portion over to an IRA and apply NUA tax treatment to the rest. If you die while you still hold employer securities in your retirement plan, your plan beneficiary can also use the NUA tax strategy if he or she receives a lump-sum distribution from the plan. The taxation is generally the same as if you had received the distribution. (The stock doesn't receive a step up in basis, even though your beneficiary receives it as a result of your death.)
In general, the NUA strategy makes the most sense for individuals who have a large amount of NUA and a relatively small cost basis. However, whether it's right for you depends on many variables, including your age, your estate planning goals, anticipated tax rates, and your state's tax laws. Also keep in mind that stock held in an IRA or employer plan is entitled to significant protection from your creditors. You'll lose that protection if you hold the stock in a taxable brokerage account.
10-Year Income Tax Averaging and Special Capital Gains Treatment
If you were born before 1936, there are two other special tax rules that may apply to your lump-sum distribution: 10-year income averaging and special capital gains treatment. For more information refer to IRS Publication 575. Be sure to consult a tax professional to determine if your lump-sum distribution qualifies for these special tax rules, and whether they make sense for you.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
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