The decision you make at the time you must take your 401k distribution could make the difference in paying tens of thousands of dollars in income taxes. Here are the major choices available to you.
Rollover, Pay Tax or NUA?
When its time to retire or leave your current employer:
- you can rollover the balance to an IRA
- you can pay tax today on your withdrawal or
- you can exercise the NUA rules if they apply
If you are retiring from your current job and want to see your 401k distribution continue to grow tax sheltered, place the distribution in an IRA. The best way to handle this is you have the plan administrator at your company send the 401k withdrawal directly to your IRA custodian. This will eliminate the requirement for any withholding tax, mistakes or complications. You may choose to roll the distribution into a Roth IRA and that decision can be made with the assistance of your accountant or financial advisor.
You can also rollover the distribution into almost any type of existing retirement account you may already have (e.g. keogh, profit sharing, SEP-IRA, etc).
Pay the Tax Now
This is the worst alternative and would only apply if you need to spend your 401k distribution, if for example, you plan to buy a yacht and sale the seven seas. Even if that is your situation, it is best to get a loan on the yacht and then withdraw a little each year from the 401k to pay off the loan. By withdrawing a little each year, you avoid the possibility of one huge tax in a single year that could push you into a higher tax bracket.
Net Unrealized Appreciation (NUA)
One important point to remember for those who have employer stock in their 401k plans is the NUA (net unrealized appreciation) rule, which allows you to sell your employer stock in a separate transaction that could be taxed largely as a capital gain instead of ordinary income. If you plan on selling the employer stock separately, be certain not to include it when you roll over the balance to your IRA. You will separate your 401k distribution into employer stock and the other assets to be rolled over.
Note that at this writing, December 2012, the rules on taxation of capital gains may change. This change will impact (probably negatively) the advantage of the NUA rules. But for now, the rules can be a significant advantage as this example shows:
Martha is just retired and has company stock in her profit sharing plan. The cost of the stock was $200,000. But it is worth $1 million now. If she were to rollover the $1 million to her IRA, the money would grow tax-deferred until she took distributions. At that time, the withdrawals would be taxed as ordinary income. When Martha dies, her beneficiaries will pay ordinary income tax on all of the money they receive.
But if Martha withdrew the stock from the plan rather than rolling it into her IRA, her tax situation would be different. She would have to pay ordinary income tax on the $200,000. However, the $800,000 would not be taxable. And she will not have to worry about RMD. If she eventually sells the stock, she will pay the lower capital gains tax on the NUA and any additional appreciation.
Martha’s beneficiaries will not receive a step-up-in-basis for the NUA. However, they will only pay at the capital gains rate. And appreciation between the distribution date and the date of death will receive a step-up-in-basis; therefore will pass income tax free.