Retirement planning.

This article discusses an underutilized strategy for reducing income taxes on company stock distributed from a qualified retirement plan, including a profit-sharing plan, Sec. 401(k) plan or employee stock ownership plan (ESOP). A Sec. 401(k) plan is a qualified profit-sharing plan or stock bonus plan to which employees may make pre-tax elective deferrals out of compensation.

Particular rules apply to appreciated employer stock included in a lump-sum distribution. The gain on the securities, while they are held by the qualified retirement plan (the net unrealized appreciation (NUA)), is not subject to tax until the taxpayer elects to have the NUA included in income at the time of distribution. If the election is not made at the time of distribution, the gain is recognized when the securities are sold.

For the last two decades, workers at large public companies have been accumulating shares of their employers' stock by purchasing shares in qualified plans. In addition, many companies match employee contributions as part of their 401(k) plans. Currently, about 20% of the estimated 1.6 trillion dollars in 401(k) plans is invested in company stock. It is not unusual for clients to have sizeable 401(k) balances that include a large block of company stock.

Employees who are changing jobs or near retirement age are faced with what to do with their 401(k) balances. One option is to continue owning company stock in the qualified plan; another is to take a lump-sum distribution.

A lump-sum distribution is a distribution from a qualified retirement plan of the balance to the credit of an employee made within one tax year of receipt. The term "balance to the credit of an employee" means either the vested (nonforfeitable) account balance that will be distributed from a defined contribution plan or the vested (nonforfeitable) accrued benefit that will be distributed from a defined benefit plan.

The distribution must be made on account of the employee's death, attainment of age 59 1/2, separation from service (except self-employed individuals) or disability (self-employed only). A lump-sum distribution can be made from a profit sharing plan if the employee has attained 59 1/2 even though termination has not occurred; see Letter Rulings 9721036, 8810088 and 8805025.

A distribution will not qualify as a lump-sum distribution unless the employee was a plan participant for at least five of the employee's tax years prior to the distribution. The IRS has ruled that plan participants who have their entire account balances transferred directly from an old plan to a new plan may include years of participation in both plans to satisfy the five-year participation requirement.

Special rules apply to appreciated stock of the employer included in a lump-sum distribution. These rules apply to employer securities distributed from an ESOP or any other type of qualified retirement plan. The gain on the securities while held by the qualified retirement plan (the NUA) is not subject to tax until the securities are sold by the recipient, at which time the gain is eligible for capital gain treatment; see Sec. 402(e)(4):

* The basis of the securities (the value when contributed to the plan) is includible in income on distribution. If the value of the securities at the time of the distribution is less than their basis, the total value of the securities is taxable in accordance with the general rules applicable to lump-sum distributions. This may include 10-year averaging for a taxpayer born on or before Jan. 1,1936.

* If the distribution consists solely of employer securities (plus cash of $200 or less in lieu of fractional shares), no withholding is required; see IRS Publication 575.

* If a distribution is taken from a qualified plan before age 55, there will be a 10% early withdrawal penalty, but only on its cost basis. In other words, if an employee receives a distribution from a qualified retirement plan after separation from service, during or after the calendar year in which the employee attains age 55, the penalty tax will not apply; see Sec. 72(t)(2)(A)(v) .

"Separation from service" and "termination of employment" are synonymous. Separation from service does not occur when the employee continues on the same job for a different employer as a result of a corporate transaction (e.g., merger or sale). This is known as the "same desk" rule. Separation of service occurs only on death, retirement, resignation or discharge.

* The cost basis coming out of the plan will not receive a step-up in basis to the market value on the distribution date when sold (Rev. Rul. 69-297).

* Subsequent gain from the market value on the date of distribution should receive a step-up in basis (Notice 98-24).

Advantages of taking in-kind distribution of employer securities include:

* Paying income tax only on cost basis, not on NUA.

* Even if sold shortly after distribution (i.e., held for fewer than 12 months), it would be considered a long-term capital gain, taxed at 20%.

* Clients can make gifts to a spouse to fulfill the unified credit amount.

* The shares can be given to others as part of an estate gift-giving plan.

* Not rolling over the stock into an IRA will reduce required minimum distributions, thus lowering current income tax.

* Having immediate access to a potentially enormous windfall.

* Could re-allocate stock proceeds into other investments after taxes.

If a client holds on to the NUA stock until death, the heirs will receive a step-up in basis. When the heirs sell the stock, their basis will be the value of the stock at the date of death, thus escaping capital gains tax on the accumulated gain. Unfortunately, the client does not escape estate taxes.

As an alternative, a client could roll the stock into an IRA. The results of this action would include:

* The heirs will not get a step-up in basis.

* All distributions will be taxed as ordinary income, and what is left will be included in the client's estate.

* Rolling the stock into an IRA will increase required minimum distributions, thus raising the income tax due.

Example 1: W participated in a profit-sharing plan until 1999, when he retired at age 55. In 2000, at age 56, W received a single-sum distribution of his plan benefits. Because W separated from service during or after the calendar year in which he attained age 55, his receipt of benefits will not be subject to the penalty tax. (This exception does not apply to distributions from an IRA; see Sec. 72(t)(3)(A).)

Example 2: M, a participant in a profit-sharing plan, terminated employment and received employer securities and cash. After checking with his employer, M took a lump-sum stock distribution and directly rolled over the cash to an IRA. M chose to defer income tax on the NUA on the employer securities.

Even though M chose to defer income tax on the NUA, he may be subject to the 10% penalty on early withdrawals (unless an exception applies).

Example 3: In 1999, B decided to take early retirement at age 54, after a 20-year career with a major software company. B's 401(k) balance had swelled to over $1 million, due to the sharp increase in the value of company stock held in the qualified plan over the last several years.

In 2000, B expresses his interest in a second career, but needs cash to start his new venture. In addition, he is also thinking about investment diversification.

B's cost basis is $100,000 on stock worth $1 million and his former employer allows in-kind stock distributions.

B has several options. He could leave everything in his 401(k) plan; this, however, would not address his cash needs for his new venture.

If B rolls over the company stock to an IRA, there is no immediate tax consequence, but capital gain property has now been converted to ordinary income property. Distributions from an IRA are taxed at ordinary rates. B's need for cash is not solved, but the sale of the stock inside the IRA can take place and diversification could occur.

If B takes an in-kind distribution of all shares, ordinary income taxes will be paid on the cost basis (approximately $40,000, assuming the highest Federal bracket). B can elect to have the NUA included in income at the time the distribution is received and be subject to the long-term capital gains rate. This election is made on B's return for the year in which the distribution was received. The potential tax savings are enormous.

If B did not immediately sell the stock after distribution, the actual holding period in the hands of the distributee determines the capital gains rate that applies. B's needs for cash and portfolio diversification can be met and at a substantial tax savings.

If B did not have the above-stated needs, he could take an in-kind stock distribution, pay tax on the cost basis and hold onto the stock for future appreciation.

The retirement plan distributions rules are amazingly complex. Before advising a client, CPAs need to know the kinds of distributions the plan allows. An adviser should particularly review the summary plan document to determine what options are available. Most companies allow lump-sum distributions, but not all allow stock distributions.

In determining what strategy makes sense, certain issues must be considered. Is the NUA big enough? Can the client afford to pay the taxes right away? Is the client eligible for 10-year averaging? Is portfolio diversification an issue? Significant stock option holdings should be considered. A partial distribution may be an option, with the remainder rolled over to an IRA. Further, the issue of portfolio diversification and asset allocation will have to be addressed.

For clients in the right situation, there may be strategies that should definitely be considered.

Editor's note: Dean Mioli is a Manager of the AICPA Personal Financial Planning team.

The author's views, as expressed in this column, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specified committee procedures, due process and deliberation.

If you would like further information about this article, contact Mr. Mioli at [phone] or [e-mail].

Dean Mioli, CPA Technical Manager AICPA Jersey City, NJ