Many retirees have employer stock in their 401(k) and profit sharing plans. In these cases, there is an opportunity for converting ordinary income (which could be taxed at rates up to 39.6%) into capital gains income taxed at only 20%.
Here's how. Rather than rolling over the employer stock into an IRA, take actual distribution of the shares. You will pay tax (at ordinary income rates) on the basis of that stock. The basis is the value of the shares when they were originally put into the plan. When you eventually sell the shares, you will be taxed on the unrealized appreciation as a capital gain. Had you rolled-over the shares into an IRA, you would pay ordinary income on the entire value of the shares as they are withdrawn from the IRA.
Let's look at an example. Joe has a 401(k) plan at ABC Manufacturing. He invests his contributions into company stock during his tenure—a total investment of $100,000. When Joe is ready to retire, the shares are worth $600,000. Let's first assume that Joe rolls over the shares into an IRA. He then reaches age 70½ and must begin taking distributions from his IRA and paying taxes on those withdrawals at ordinary income rates (up to 39.6%). He will pay these full rates on all of his shares. Assuming no further appreciation above the $600,000, Joe would pay tax of $237,600 on the shares (at the 39.6% rate).
But let's assume that Joe read this article. He does not roll over the shares. He takes them as a distribution and pays tax of $39,600 immediately on the basis (39.6% of $100,000). Later, he decides to sell the stock (at his discretion because he is not subject to the 70½ rule as the shares are not in an IRA) and he pays capital gains tax of $100,000 (20% of $500,000).
His total tax bill is $139,600 rather than the $237,600 he would have paid had he rolled his shares into an IRA. That's a cool savings just shy of $100,000—enough to pay for plenty of great vacations for Joe and his wife.
Retiring in the next 3 years? Don't miss out on many planning opportunities that the mutual fund companies won't explain or your CPA forgets to mention. Call for a retirement planning analysis and start organizing your affairs to make the most of your financial options.