Taxpayers may be overlooking an important break on income tax when they take a lump sum distribution from a 401k plan. A lump-sum distribution means the entire balance of the account is withdrawn within a single calendar year following a triggering event – you leave your employer, suffer a disability, reach age 59½ or die. (Note that if you leave your employer before you turn 55 and you take a lump-sum distribution rather than rolling the funds into another qualified account, you may be subject to a penalty.)
If the distribution meets the definition of a lump-sum, you may be able to avoidincome tax on the net unrealized appreciation (NUA) of stock of your employer if that stock is placed into a taxable brokerage account. If you roll your employer stock into an IRA, the cost basis resets to the account value on thday of the rollover. You pay no income tax at the time of the rollover, but you do pay income tax on distributions you take when you are retired. Gains on contributions are subject to income tax but not capital gains tax.
Let’s say you have a 401k account worth $1 million, of which $500,000 (current market value) is in employer stock. First, you have to meet the lump-sum distribution requirement and move all the assets of the account within a single calendar year. Make a mistake on this point and you may wind up owing not only the tax you thought you avoided, but penalties as well.
The next step is to segregate your employer stock. You can roll the rest of the account into an IRA where it can continue to grow tax-deferred. The employer stock goes into a taxable account, paying income tax on the cost basis of the stock – the amount paid to purchase it. Using our example, let’s say that the cost basis on the stock now valued at $500,000 is $50,000. You would pay income tax at your current rate on the $50,000. At the time you sell the stock, you will pay capital gains tax on the appreciation – the difference between the $50,000 cost basis and the current market value on the date of the sale (which may be higher or lower than the current market value of $500,000 on the date of distribution.) Thus, you have avoided paying income tax on the $450,000 of NUA.
There is no requirement to hold the segregated stock a certain amount of time after the lump-sum distribution in order to utilize the NUA exemption. If you’ve started taking retirement distributions, however, or you converted employer stock to cash within the plan, the NUA doesn’t apply. This special tax break applies only to untapped 401(k) accounts taking a lump-sum distribution of income within a single calendar year, with the employer stock being taken in kind, not in cash. These points bear repeating, as mistakes can be costly. Beneficiaries of 401(k) accounts can also use the NUA if they meet the same requirements.
Before making any decisions regarding rolling over or taking distributions from a 401(k) – whether you are the account owner or a beneficiary, you should consult financial and tax professionals to determine which options provide the most benefit with the least tax consequences.