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Tricky Rules Of A 401(k) Conversion

21492151_sFolks, over the years I have suggested you seek advice that encompasses three areas of planning to create a sound financial system. You must incorporate advanced tax planning, income planning and investment planning into that system. And all three need to work together. Unfortunately, I find that most of the time when people seek financial help, they only get advised on the investment piece, because that is the advisor’s focus. But to create a sound financial system, you must have all three. We need income planning because we must generate income that is measurable, predictable and sustainable. We don’t want to run out of money before we run out of time. And advanced tax planning allows us to legally pay the least amount of tax. In retirement if we can find strategies to lower our taxes, isn’t that a pay raise?
 
Let me tell you about my new friends John and Sandy. They are 66 and 63, respectively, and retired to Sandwich from central Connecticut last year. John worked for the same defense company for almost 40 years while Sandy stayed home raising their three kids. John has about $1,500,000 in his 401(k) and he told me that his current advisor in Connecticut suggested that he just “roll over” his 401(k) into an IRA. They called me for a second opinion and, frankly, it is good they did. A simple rollover, as was suggested to John and Sandy, would have potentially cost them a lot of money.
 
John and Sandy came in last week. I want to share with you how this meeting unfolded.
 
Once we talked for a bit to get to know each other, John and Sandy shared with me their financial statements to review. Page one of John’s 401(k) statement listed all of his stock and bond mutual funds. It was on page two that red lights started to flash in my head. About $600,000 of John’s 401(k) consists of company stock, which has appreciated by almost 500 percent since he acquired it.
 
I asked John if his current advisor mentioned the term Net Unrealized Appreciation (NUA) to him? He said no.
Hmmmm . . . John needed some help.
 
You see, when an employer-sponsored plan, such as a 401(k), holds company stock, there is a special little provision in the tax code that allows a taxpayer to take advantage of potentially lower tax rates on any appreciation of that company stock.
 
Under normal circumstances, money contributed to an employer-sponsored retirement plan grows, tax-deferred, until it is withdrawn. Distributions are then subject to ordinary income tax rates, which often times are much higher than long-term capital gains rates.
 
Net Unrealized Appreciation is the difference in value between the cost basis of shares and the current fair market value of the shares held in a tax-deferred account (i.e., NUA is the growth of those shares). The tax provisions of NUA allow an individual to take advantage of long-term capital gains tax rates on any such NUA. Generally, an individual will pay ordinary income tax on only the original cost of any company stock purchased within the employer-sponsored plan, but any gains (the NUA) are taxed at long-term capital gains tax rates, which, as mentioned above, are often more favorable than ordinary income tax rates.
 
Let me use John and Sandy as an example of how the NUA provisions work. John will need to take a lump sum distribution from his 401(k) in one single calendar year. It must be the total balance of his account, which will include both his mutual funds and his appreciated company stock. We will roll his mutual funds into a traditional IRA; that’s the easy part. Under the NUA rules, we will NOT roll John’s company stock into an IRA but instead will move it to a taxable investment account, in kind. This means we move the actual stock rather than selling the stock and moving the money. When we move the stock in kind to John’s taxable account, John will be required to pay ordinary income tax on the original cost of the stock, but if done correctly, the appreciated portion of the stock will only be subject to long-term capital gains tax when the stock is sold.
 
If, on the other hand, John had sold the stock before he moved it, as his current advisor suggested, he would have been unable to take advantage of the NUA provisions. John would be paying Uncle Sam a heck of a lot more money because all distributions from his IRA will be subject to ordinary income taxes.
 
Let’s crunch the numbers. John has $1.5 million in his 401(k), of which approximately $600k is in company stock. John paid $50k for the stock so the NUA is $550k ($600k fair market value – $50k cost = $550 NUA). We will roll over $900k to a traditional IRA. But the $600k will be transferred to a taxable account in both John and Sandy’s names. Upon its transfer to the taxable account, let’s assume John and Sandy will have to pay 25 percent ordinary income tax on the original $50k of stock, which totals $12,500. The remaining $550k (the NUA) will be subject to long-term capital gains tax upon its sale, assuming that is the gain when the stock is sold. Assuming they’re in the 25 percent tax bracket, the NUA will be taxed at a capital gains rate, which is much lower than 25 percent personal income tax rate. This potentially saves John and Sandy approximately $55,000 in taxes that otherwise would be lost to Uncle Sam!
 
Needless to say John and Sandy are glad they made the call. Folks, the rules are complicated and it does get tricky out there, so remember to be vigilant and stay alert, because you do deserve more.