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Author: TMFMax Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 25223  
Subject: Re: 401(k)s and ESOPs Date: 8/25/1999 10:32 AM
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<<The company says she may have the ESOP portion of her account distributed in cash or an actual stock certificate. Are the taxable (capital gains) portion of this ESOP account elligible for rollover into an IRA account? From what I understand, all taxable monies are elligible for rollover but I haven't read any specific rules relative to funds held in the ESOP portion of 401(k) plans. Thank you for your time and knowledge >>

Gglass555,

I've cut and pasted a rough draft of what will soon be put up on the site as part of a collection on taking money/stock from retirement plans. (TMF Pixy is the author.) Hopefully this will help answer your question:

_________________________________________

Ever wonder what happens to the company stock you have accumulated in your company profit sharing plan when you retire or otherwise leave your job? For some, the value of these shares can be a considerable amount. Therefore, what happens to these shares may have a significant income tax impact on you or on your heirs. When employer securities are received as part of a lump sum distribution from a defined contribution plan, you may handle that distribution in one of four ways: (Note: In all cases, fractional shares will be redeemed by the plan for cash.)

a. Transfer the shares to an Individual Retirement Account (IRA).
b. Sell the shares and transfer the cash from that sale to an IRA.
c. Keep the stock and pay ordinary income taxes on the cost basis of the shares. Gains on a subsequent sale are eligible for capital gains treatment.
d. Keep the stock and pay ordinary income taxes on the market value of the shares at the time of distribution.

In the first two choices, the distribution avoids current taxation by transferring the shares or cash to an IRA. The tax deferral continues until funds are withdrawn from that IRA. On withdrawal, the sum taken will be taxed at the ordinary income tax rates in effect in the year of distribution. If the distribution from the IRA consists of actual shares instead of cash, the shares will be valued at market as of the day of withdrawal, and that amount must be declared as income for tax purposes. The market value of those shares becomes the new basis, and the holding period for calculating capital gains on a future sale of those shares begins on the day after the day of distribution.

In the third choice, you will pay ordinary income taxes on the cost basis of the shares taken in the year of distribution. Your plan administrator will tell you what the cost basis is. Your holding period in those shares begins on the day after the day the plan trustee delivers the shares to the transfer agent on your behalf. Any unrealized appreciation (i.e., the difference between market value on the day of distribution and your cost basis) is not recognized until a later sale; however, any gain attributable to the excluded appreciation as of the distribution date from the plan will be treated as a long-term capital gain regardless of your holding period. Any gain exceeding that as of the day of distribution will be considered a long or short-term capital gain based on your holding period after the shares were distributed.

In the fourth choice, you will pay ordinary income taxes on the market value of the shares as of the day of distribution from the plan. Your holding period in those shares begins on the day after the day the plan trustee delivers the shares to the transfer agent on your behalf. Any gain on a subsequent sale will be considered a long or short-term capital gain based on your holding period after the shares were distributed.

Which is the best choice for you? Ah, now, there's the rub. Like so many things connected with taking distributions from a retirement plan, the answer depends on a number of factors. These include your desire to retain the stock, your income tax situation, and your estate planning desires. Let's consider our friend, Al, for a moment. Al is in the 28% federal income tax bracket, and expects to stay there in retirement. He likes his company, believes its prospects are good, and wants to retain the shares he owns. At the same time, he wants to minimize any taxation issues for his heirs after he dies. Al has 1000 shares of company stock in his plan with a cost basis of $10 per share. The stock's market value today is $50 per share. He expects those shares to increase in value at a rate of 9% per year. He is considering either a transfer of these shares to an IRA or their issuance to him. He wants the option that best fits his situation.

If Al puts the shares in his IRA, he has no immediate tax impact to worry about. But he could still sell the stock immediately, withdraw the $50K sales proceeds from his IRA, and pay federal income taxes of $14,000, thus netting a total of $36K. (Note: He could get the same result by using the fourth option. Any subsequent gains at the time of a future sale would then be eligible for capital gains treatment.) More likely, though, he will let them sit. At a 9% expected growth rate, his shares would be worth $76,931 in five years. If he cashed in those shares at that time or if he died, then he or his heirs (ignoring the spouse's ability to take over his IRA) would face a federal income tax bill of $21,541. That means he or his heirs would net $55,390 after paying the federal income tax due on the sale.

If Al takes the shares today, he would pay $2,800 in ordinary federal income taxes on his $10K basis. He could then immediately sell those shares for $50K, and (ignoring commissions on the sale) pay long-term capital gains taxes of $8K to net $39,200 after we also consider his original tax bill. That's some $3.2K more than the IRA would produce following the same procedure. But again, it's more likely he would wait before cashing in those shares. In five years, the shares would sell for $76,931 just as they would in the IRA. His gain, though, would be taxed at a capital gains rate of 20%, which means his tax bill would be $13,386, and he would net $60,745 after we also deducted the original tax bill he paid on those shares at retirement. If we consider the lost "opportunity cost" as 9% on that original tax payment of $2.8K, then we should deduct another $1,508 in foregone earnings on that $2.8K as well. That would make Al's actual net $59,237, a sum that's still $3,847 greater than that produced by the IRA option. And if Al died prior to selling those shares five years from now? His heirs would take the stock with a basis equal to its market value at the time of Al's death. Their basis would be $76,931. If they sold everything immediately, they would owe Uncle Sammy nothing.

In Al's case, taking the stock and paying federal income taxes on the cost basis seems the Foolish way to go. By doing so he lessens the potential tax burden for both himself and his heirs. Faced with a similar distribution choice at retirement, that approach may be appropriate for you, too. You'll have to run the numbers to be sure, but at least now you're aware you have that choice.
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