Capital gains on retirement money

Q: I recently retired and need to take my retirement money out of my employer's ESOP. I assume if I don't put this into another retirement account that it will all be taxable to me. But some of my employer's literature says I can use capital gains rates on the distribution. Is that right?

A: Employee Stock Ownership Plans (ESOPs) are employer-provided retirement plans that have an added feature. Instead of investing solely in publicly offered mutual funds and other securities, the ESOP may also invest in the stock of the employer. These plans are used to motivate and reward employees, and in some cases to assist in the transfer of ownership to an employee group.

To establish an ESOP, a company sets up a trust and then contributes company stock (or cash that is used to purchase company stock). Alternatively, the ESOP can borrow money to purchase the company stock and later the company makes cash contributions to the ESOP so the debt can be repaid. Shares in the trust are allocated to individual employee accounts based on compensation. Typically employees vest, or acquire a right to the shares in their account, over a period of time not exceeding six years.

In your case, now that you have retired, the ESOP will begin to make distributions to you based on the provisions in the plan. These distributions are similar to money taken out of an IRA or other qualified plan. The fair market value of the stock and cash you receive, less any after-tax contributions you made to the plan, will be taxable to you unless you timely roll the funds into another qualified plan or IRA. If the funds are not rolled over, this will be ordinary income subject to the rate of tax applicable to you when you file your next tax return.

One of the great, but seldom used, advantages of an ESOP (and other employee stock plans) is that because the distributions from the plan can often be made in employer stock rather than cash, the special rules on Net Unrealized Appreciation (NUA) apply. NUA is simply the increase in stock value between the time of contribution of the stock to the plan and the date of distribution. So if an employer contributes $100 of stock in 2004 and ten years later when a distribution is made the stock is valued at $130, the NUA is $30.

This NUA is significant because special tax rules allow the recipient of the stock, if the distribution is a single lump-sum distribution, to defer paying tax on the NUA until the actual stock is sold. Better still, if the recipient waits a year from the date of distribution, the NUA is taxed at the capital gains rates rather than the ordinary income rates. I have had clients save significant tax dollars using this provision.

Here's an example: Over the years of her employment Sally's employer contributed and allocated stock valued at $300,000 to her account. Sally retires when the stock's fair market value is $500,000. If Sally takes a distribution of the entire account in cash, she will be taxed on the full $500,000 value. If her tax rate is 40 percent she will pay tax of $200,000, netting her $300,000 for her retirement.

If, however, Sally takes the entire distribution in stock she will only be taxed on $300,000. Again assuming a tax rate of 40 percent she will owe taxes of $120,000. Assuming Sally can pay this tax without dipping into the stock she just received, and assuming she holds the stock for a full year and then sells it for $500,000, she will report a capital gain of $200,000 (the NUA amount). Assuming a capital gains rate of 23.8 percent (that's the worst it can get!), the tax owed will be $47,600. Sally will have paid total tax of $167,600 which is a savings of $32,400 over the distribution of cash. If the stock has further appreciated in value since the initial distribution, or if the actual tax brackets are lower the savings can be even greater.

Obviously there are lots of moving parts to this strategy and you need to look at your individual situation. You should consult with your tax advisor.

Published: Wed, Aug 13, 2014