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Lump-sum distributions may result in 401(k) tax breaks

Tue., Nov. 10, 2009, midnight

Taxpayers may be overlooking an important break on income tax when they take a lump-sum distribution from a 401(k) plan.

A lump-sum distribution means the entire balance of the account is withdrawn within a single calendar year following a triggering event – you leave your employer, suffer a disability, reach age 59 1/2 or die. (Note that if you leave your employer before you turn 55 and you take a lump-sum distribution rather then rolling the funds into another qualified account, you may be subject to a penalty.)

If the distribution meets the definition of a lump sum, you may be able to avoid income tax on the net unrealized appreciation (NUA) of stock of your employer if that stock is placed into a taxable brokerage account. The difference in the value of the company stock from the time it was purchased to the time of distribution is the NUA.

To qualify, the distribution must be a lump sum, meaning the entire plan balance, not just the stock, must be withdrawn in one tax year. Other non-company stock assets in your plan may be rolled over tax free to an IRA or another qualified company plan and continue to grow tax deferred.

Let’s say you have a 401(k) account worth $1 million, of which $500,000 (current market value) is in employer stock. Using our example, let’s say that the cost basis on the stock now valued at $500,000 is $50,000. You would pay income tax at your current rate on the $50,000. At the time you sell the stock, you will pay capital gains tax (a maximum of 15 percent) on only the appreciation – the difference between the $50,000 cost basis and the current market value on the date of the sale, which may be higher or lower than the market value of $500,000 on the date of distribution. Thus, you have avoided paying income tax on the $450,000 of NUA.

There is no requirement to hold the segregated stock a certain amount of time after the lump-sum distribution in order to use the NUA exemption. If you’ve started taking retirement distributions, however, or you converted employer stock to cash within the plan, the NUA doesn’t apply. This special tax break applies only to untapped 401(k) accounts taking a lump-sum distribution within a single calendar year, with the employer stock being taken in kind, not in cash. These points bear repeating, as mistakes can be costly. Beneficiaries of 401(k) accounts can also use the NUA if they meet the same requirements.

Before making any decisions regarding rolling over or taking distributions from a 401(k) – whether you are the account owner or a beneficiary – you should consult financial and tax professionals to determine which options provide the most benefit with the least tax consequences.

Jerry Felts is a certified financial planner and member of the local Financial Planning Association chapter.

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