Ed Florreich knew he would have to take a distribution from his retirement plan when he turned 70 1/2.
That’s the age when U.S. tax laws require individuals to take money out of qualified plans, either in a lump sum or on a monthly basis according to formulas. Because retirement plan distributions require such tricky, and largely irrevocable, decisions, Florreich opted to consult a financial adviser beforehand.
It was lucky he did.
Because part of the retiree’s 401(k) was invested in his employer’s stock, Florreich could take advantage of an obscure provision in the tax code that allows retirement plan participants to take distributions of company stock in stock rather than cash.
By doing that, Florreich of Playa del Rey, Calif., was able to pay tax on only the actual cost of the stock when it went into his account, which was a tiny fraction of the account’s value. The remaining value of his employer’s stock was considered “net unrealized appreciation,” which is not immediately taxable if the stock is taken out of the account directly.
Better yet, when the unrealized gain on that stock, four-fifths of his account value, is taxed, it will be taxed at federal capital gains rates, rather than the much more costly ordinary income tax rates. That difference alone saves him thousands of dollars in federal tax.
If that weren’t enough of an advantage, this move gives Florreich increased financial flexibility.
“I don’t know why the government would have ever done anything so nice to anybody,” Florreich says.
Here’s how it works.
Let’s say you have a 401(k) account with XYZ Corp., where your employer provides matching contributions in company stock. For every $1 you put into the 401(k), XYZ matches with 50 cents worth of XYZ shares. You work for XYZ for 20 years, during which time you consistently contribute $5,000 a year to the 401(k). XYZ matches your contributions with $2,500 annually in XYZ stock.
Both the XYZ stock and your other 401(k) investments earn an average of 10 percent annually. When you retire, your account is worth $474,606; roughly $316,404 of that is in a spectrum of stock and bond mutual funds offered through the plan and the remaining $158,202 is in XYZ shares that you got through the company match.
When you decide to retire, you are likely to have several choices. You can have your company annuitize your 401(k), paying you enough monthly income to deplete your account over your expected life span or the expected life span of both you and your spouse. You can also opt to have the plan roll the entire amount of your account into a rollover individual retirement account.
Or you can choose the Florreich option, which boils down to splitting the account in two, says Craig Brimhall, a region vice president of investment products for American Express Financial Advisors based in Harrisonburg, Va.
The portion of the account that’s in non-company stock gets rolled into an IRA, which has no immediate income tax obligation. The portion that’s in your employer’s stock gets distributed to you in one lump sum, but in stock rather than cash.
Because you have not sold the XYZ shares, only the cost of the shares is taxable at your ordinary income tax rates. In this case, that cost amounts to $50,000 (XYZ’s $2,500 annual stock contributions to the plan times 20 years). The remaining $108,202 is “net unrealized appreciation,” on which you will have to pay tax only when you actually sell the shares. As a result, you pay just $15,500 in federal income tax at your ordinary rate when your pension distributes the $158,202 in XYZ shares. (This assumes you are in the 31 percent federal income tax bracket.)
But that transaction takes $158,202 of value out of your retirement plan and puts those XYZ shares into a simple brokerage account. That recharacterizes the stock from being a pension asset, taxable at your 31 percent ordinary income tax rate, to being a long-term investment asset, taxable at the more favorable capital gains rate of 20 percent.
Even if you sell those XYZ shares the next day, the gain ($108,202) will be taxed at capital gains rates rather than ordinary income tax rates. In this case, that would save you $11,902.
“One of the biggest benefits of this, aside from the income tax savings, is the estate planning rewards,” says Blake Christian, tax partner at tax and financial management firm Holthouse Carlin & Van Trigt in Long Beach, Calif.
If you happen to die before you’ve depleted a qualified retirement account, your heirs can be subject to both income taxes and estate taxes on the value of that account.
In the XYZ example, because the $158,000 taken out in stock is no longer a retirement asset, only estate taxes and capital gains taxes could apply.
Additionally, any further gain past the $108,202 that the retiree realized on the initial retirement plan distribution, would be subject to a “step-up” in basis at your death. So, if that XYZ stock appreciates by another $100,000 before you die, your heirs will still only be subject to capital gains taxes on the $108,202.
Despite the tremendous benefits that retirees can derive from section 402(a)(1) of the tax code, it appears to be widely overlooked.
Florreich, for example, consulted an attorney, a tax accountant and a financial planner. Only the planner, who had recently gone through a training session with Brimhall, knew about the provision.
When Florreich contacted his company, IBM Corp., about taking the stock in kind rather than cash, the employee benefits people knew all about Section 402(a)(1), but had never mentioned it to Florreich.
Perhaps the reason the provision is often overlooked is because it is at least 50 years old, says Neil Allen, a spokesman for CCH Inc., a publisher of tax and pension information in Riverwoods, Ill.
In the 1930s, this provision simply didn’t apply to the vast majority of the population because few companies offered employer stock within their pension plans.
Now, between profit-sharing plans, employee stock ownership plans and 401(k) accounts, employee pensions commonly include at least some percentage of employer stock. But few advisers seem to remember this often lucrative break.
WHERE TO GET INFORMATION ON RETIREMENT
Many investment firms offer information about their retirement plans through their Web sites. Naturally, these companies would like a site visitor to go with their plan. But once you get past the pitch, you can learn quite a bit about retirement saving options.
Here are just a few sites that offer useful retirement planning insights:
– Delotte &Touche (www.dtonline.com/prptoc/prptoc.htm)–Discusses how to start saving and principles of retirement planning.
– Scudder Investor Services (scudder-u.working4u.com/SU1/index.htm)–Offers the ABCs of retirement plans and how they work.
– T. Rowe Price (www.troweprice.com/retirement/trowereti reIRAHome.html)–Contains guidelines for retirement saving and information on different types of accounts.
– The Vanguard Group (majestic.vanguard.com/RRC/DA)–Provides resource center that covers wide range of retirement options.
— Knight-Ridder/Tribune
