Smart401k Blog

In the last installment of Common 401(k) pitfalls, I discussed an investor’s options for their 401(k) when they leave an employer.  In this installment, I thought I would go into a little more depth and cover some a couple of lesser known distribution strategies.  The first is a strategy used to withdraw money prior to age 59 ½ without penalty and the second involves company stock.

First let’s talk about withdrawals before 59 ½ and IRS Rule 72(t).  Typically when an employee leaves their employer prior to age 59 ½ and wants to have money paid out to them directly, a premature withdrawal penalty of 10% is applied.  However, there is a way to avoid the penalty and still be able to access the funds as long as you are 55 or older.  IRS Rule 72(t) allows an individual to access their retirement plan funds without incurring the premature withdrawal penalty provided the withdrawal is part of “substantially equal” periodic payments.  The periodic payments must continue for five years or until you are 59 ½ whichever comes last.

In order to take advantage of this benefit, you will likely first need to roll your account over into an IRA.  You may be able to employ this strategy within a company sponsored plan, but not all retirement plan recordkeepers are set up to accept 72(t) requests.  Once you have rolled your account over to an IRA you will want to either consult a financial adviser or accountant that will help you calculate your substantially equal distribution schedule using one of the following three approved IRS payout schedules:

1. The Variable Method (also known as the Required Minimum Distribution Method) – This type of distribution generally results in the lowest payout. It is calculated by dividing your account value by your life expectancy, which is based on one of three IRS life expectancy tables-single life, uniform lifetime or joint and last survivor. The same life expectancy table must be used each year.  The annual payment is recalculated each year.
2. The Fixed Annuity Method –This type of distribution provides fixed payments and typically provides a higher payout than method #1.  It is calculated by dividing your account balance by an annuity factor, which is based on the IRS life expectancy tables and a reasonable rate of interest.  If you have been taking 72(t) payments using this method and you need to reduce your payments, the IRS allows you to make a one-time only change from the fixed annuity method to the variable method.
3. The Fixed Amortization Method – This type of distribution is similar to a loan amortization schedule and generally provides a higher payout than method #1 (the variable method).  It is calculated by gradually liquidating your account balance over a number of years based on your life expectancy, or the joint life expectancy of you and your beneficiary using a reasonable interest rate.  Like the Fixed Annuity method, this method may be changed to the variable method.  This change is permitted only once

Before you rollover your account and begin payments please be aware that this strategy is not for everyone.  Notably:

• Once you begin payments you can’t change the character of the distributions without incurring a penalty plus interest on all payments received prior to age 59 ½.
• Changes in the character of the distribution include modifying the payout schedule other than the one-time change allowed to the variable method or changing IRA custodians.

The second strategy that we are going to explore in more detail is called Net Unrealized Appreciation (NUA).  You’re probably wondering what exactly is NUA?  NUA is a strategy that involves taking advantage of, as the name suggests, unrealized appreciation in company stock.  NUA comes into play when requesting a distribution that involves company stock and your cost basis is significantly lower than the current market value.

How it works – when you request a distribution involving company stock, you have the shares paid directly to you.  This will trigger a taxable event, but the tax will be based on the cost basis not the current market value.  The tax bill will be your current tax rate plus the 10% penalty (if the distribution is received prior to age 59 ½) times your cost basis.  Then when you when you sell the shares of stock, the appreciation is taxed at the long-term capital gains rate which is currently a maximum of 15%. To illustrate, let look at the following example:

Let’s say John leaves his job in 2009 and receives a lump sum distribution from his employer’s 401(k) plan when he is age 50. The distribution consists of $300,000 of cash and $200,000 worth of employer stock. The original cost basis of the distributed stock is $40,000. Thus, there is $160,000 of NUA attributable to the stock ($200,000 – $40,000). If John rolls over the $300,000 of cash into an IRA and keeps the stock, he will pay income tax plus the 10% early distribution penalty tax on only the $40,000 of stock basis. He then can continue to defer tax on the $160,000 of NUA on the stock. The tax cost including the premature withdrawal penalty would be ($40,000 times 25% (his current tax rate)) + ($40,000 times 10%) = $14,000.

When John sells the stock, the $160,000 of gain will be taxed as long-term capital gains. The capital gains tax would be $160,000 times 15% or $24,000. Compare this to the tax at ordinary rates that could be as high as $160,000 times 35% or $56,000. Thus, by not rolling over appreciated stock into an IRA, John can save as much as $32,000 in tax for a cost of $14,000.

If we continue with our example and instead of having the shares paid directly to him, let’s say that John chose to rollover the shares with the cash into his IRA. By rolling the shares over now, John does avoid current taxation but he will not be able to take advantage of long-term capital gains rates on any subsequent distributions.  This is because the $160,000 of Net Unrealized appreciation loses its long-term capital gain status and is taxed at ordinary income tax rates when distributed from the IRA.

NUA can be a very good tool for reducing your tax liability, but it is not for everyone.   As I mentioned before, when you have the shares paid to you directly, you will be incurring an immediate tax liability.  You will want to make sure that you can pay your liability before requesting the distribution.  If you need help calculating your tax liability or want to know if Net Unrealized Appreciation is appropriate for you, consult a financial adviser or accountant.

In the meantime, please feel free to contact me directly at 913.744.3376 or by email at bwendel@smart401k.com if you have any questions regarding Net Unrealized Appreciation or IRS Rule 72(t).  Also keep an eye out for the next installment of Common 401(k) pitfalls.

Buck Wendel, Investment Adviser

This entry was posted on Wednesday, January 6th, 2010 at 6:18 pm and is filed under Adviser Commentary. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.