PERSONAL FINANCIAL PLANNING

PLANNING WITH EMPLOYER STOCK IN A QUALIFIED PLAN

By Bruce E. Wertheim, CPA,
KPMG LLP

In recent years it has become common for employees to accumulate a significant amount of employer stock in their 401(k) plans. This is generally true where employers provide a matching contribution in their own stock permit or designate their stock as an investment option. In combination with other recent developments--rising stock market prices, reduction in long-term capital gain rates, and elimination of the 15% excise tax on large accumulations in, or from, qualified plans--these accumulations of stock present a unique planning opportunity.

Under certain circumstances, employees may have the opportunity to take a distribution of employer stock with little or no income tax due currently and, upon sale of these securities, pay tax at the reduced long-term capital gain tax rate of 20%. There are many financial considerations that need to be analyzed before choosing this planning technique; however, if done properly the results can be beneficial.

Because of the booming securities markets, it would be expected that the employer stock included in the portfolios of many qualified 401(k) plans will have appreciated above the initial cost and will have accumulated a significant amount of net unrealized appreciation (NUA). Under IRC section 402(e)(4)(A), if the employee elects to receive a lump-sum distribution of shares, the income tax on these shares is postponed until the ultimate sale. Based upon this option, the following tax planning techniques can potentially benefit individuals that have appreciated employer stock in a qualified plan.

Rollover to IRA

Prior to 1998, many retiring employees elected to directly roll the 401(k) balances over to an IRA. This approach was advantageous because it postponed the tax until distribution. The long-term capital gain rate was 28% on NUA, which, in many circumstances, was not low enough to justify the cost of prepaying the tax on the distribution. It also provided a means to diversify the employee's portfolio by choosing alternative investment vehicles at no tax cost.

The rollover to an IRA and then conversion of the IRA to a Roth IRA was another technique that could have beneficial results. The lowering of the capital gain rates in 1998 has made other approaches more attractive.

Lump-Sum Distribution

As mentioned earlier, IRC section 402(e)(4)(A) provides a special rule for a distribution from a plan that includes employer stock. In order to qualify for this special treatment, the payment must be a lump-sum distribution as prescribed by IRC section 402(e)(4)(D). The NUA on employer stock is not taxed when the stock is distributed. Rather, it is generally taxed at long-term capital gain rates when the stock is sold (currently 20%).

In the year of the lump-sum distribution, tax will be due on the fair market value of the stock distributed, less the amount of the NUA. Special tax treatment under the five-year or 10-year forward averaging rules may be available to further reduce the amount of tax due on the distribution. Under the five-year forward averaging rules, the tax that is due is generally equal to five times the tax on one-fifth the income computed at tax rates for an unmarried individual with no exemptions or reductions.

Individuals born before 1936 can elect to use 10-year forward averaging. The tax under 10-year averaging is calculated using the same method as under the five-year, except that the tax on the distribution is equal to 10 times the tax on one-tenth the income using rates in effect for 1986. Please note that five-year forward averaging is only available with respect to distributions made before January 1, 2000.

If an individual elects forward averaging treatment with respect to a distribution, it applies to all lump-sum qualified plan distributions made within the same taxable year. Therefore, individuals should be very careful about coordinating the distributions of other qualified plans in the year of retirement or separation of service.

If the shares distributed from the qualified plan are not sold during the life of the individual, the amount of the NUA will be treated as income in respect of a decedent (IRD). Under IRC section
691(a)(1), an amount is considered IRD if the decedent was entitled to the income at the time of death, but such income was not properly includable in income in the year of the individual's death or a prior period. IRD is included in the taxable income of the person who receives it by reason of the decedent's death. There is an income tax deduction available to the recipient for the estate tax paid on
the IRD.

Step-up in Basis

The basis of property in the hands of a beneficiary is the fair market value of the property at the date of the decedent's death. Under IRC section 1014(c), however, the step-up in basis rules do not apply to property that constitutes a right to receive an item of IRD.

In any event, there is no income tax on the unrealized appreciation of employer stock at the time of death (other than the NUA), either to the decedent or to the beneficiary, as long as the stock is not sold. The appreciation in excess of the NUA would receive a step-up in basis at the time of the individual's death. Although the amount of the IRD/NUA receives no step-up in the hands of the beneficiary, the tax would not be payable on the NUA until the stock was ultimately sold. If a surviving spouse continues to hold the stock, the beneficiary would receive a further step-up in basis for the increase in value while held by the surviving spouse.

For example, assume A's 401(k) plan holds $1 million in employer stock at retirement. The cost basis of the stock is $400,000, and the NUA is $600,000. A takes a lump-sum distribution of the entire balance, pays tax on the cost basis of the stock, and does not sell any of the shares. At A's death several years later, the stock has a value of $2 million. A's beneficiary inherits the stock and receives a basis of $1.4 million ($2 million FMV­$600,000 NUA).

Partial Rollover

An alternative to the direct rollover to an IRA is to elect a lump-sum distribution and then roll over the distribution into an IRA except for shares having a fair market value equal to the NUA. Under IRC section 402(c), there would be no tax at the time of distribution. However, assets that are rolled over into the IRA would be subject to the minimum distribution requirements beginning no later than April 1 of the year following the year in which the employee reaches age 70^zs.

Any amounts remaining in the IRA at death would be IRD. It is not necessary for the IRA to continue to hold employer stock, as there is no NUA associated with the rollover. Accordingly, from a financial planning perspective, diversification of the portfolio can be partially accomplished through the IRA with no tax until distribution. The beneficiary of the IRA would pay tax on the fair market value of the amounts received from the IRA at ordinary income tax rates.

Financial Planning Considerations

Putting the tax consequences aside, from a financial planning point of view, the following factors should be considered when choosing a distribution alternative from a qualified plan:

* The timing and amounts of cash flow needed in retirement;

* The amounts the employee wishes to leave to heirs at death;

* Possible changes in the tax law made to the ordinary or capital gain tax rates over the joint life expectancies of the employee and his or her spouse;

* Whether holding large amounts of employer stock over long periods is a wise investment decision;

* Whether the rate of return on the employer stock during all relevant periods is comparable to or better than the rate of return that can be expected on alternative investments.

Individuals primarily interested in maximizing retirement income should consider utilizing a rollover to an IRA. Individuals that will not need the retirement income, are willing to accept the investment risk of holding employer stock, and wish to leave an estate to their heirs should consider the lump-sum distribution and incur the tax. Finally, those who wish to receive some retirement income (or don't want the risk of a substantial investment in the employer's stock) and wish to leave some employer stock to heirs should consider the partial rollover. *

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA/PFS

Contributing Editors:
Alan J. Straus, CPA

David R. Marcus, CPA
Paneth, Haber & Zimmerman LLP

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.