Retirement planning.

• Author: Mioli, Dean

This article discusses an underutilized strategy for reducing income taxes on company stock distributed from a qualified retirement plan, including a profit-sharing plan, Sec. 401(k) plan or employee stock ownership plan (ESOP). A Sec. 401(k) plan is a qualified profit-sharing plan or stock bonus plan to which employees may make pre-tax elective deferrals out of compensation.

Particular rules apply to appreciated employer stock included in a lump-sum distribution. The gain on the securities, while they are held by the qualified retirement plan (the net unrealized appreciation (NUA)), is not subject to tax until the taxpayer elects to have the NUA included in income at the time of distribution. If the election is not made at the time of distribution, the gain is recognized when the securities are sold.

For the last two decades, workers at large public companies have been accumulating shares of their employers' stock by purchasing shares in qualified plans. In addition, many companies match employee contributions as part of their 401(k) plans. Currently, about 20% of the estimated 1.6 trillion dollars in 401(k) plans is invested in company stock. It is not unusual for clients to have sizeable 401(k) balances that include a large block of company stock.

Employees who are changing jobs or near retirement age are faced with what to do with their 401(k) balances. One option is to continue owning company stock in the qualified plan; another is to take a lump-sum distribution.

A lump-sum distribution is a distribution from a qualified retirement plan of the balance to the credit of an employee made within one tax year of receipt. The term "balance to the credit of an employee" means either the vested (nonforfeitable) account balance that will be distributed from a defined contribution plan or the vested (nonforfeitable) accrued benefit that will be distributed from a defined benefit plan.

The distribution must be made on account of the employee's death, attainment of age 59 1/2, separation from service (except self-employed individuals) or disability (self-employed only). A lump-sum distribution can be made from a profit sharing plan if the employee has attained 59 1/2 even though termination has not occurred; see Letter Rulings 9721036, 8810088 and 8805025.

A distribution will not qualify as a lump-sum distribution unless the employee was a plan participant for at least five of the employee's tax years prior to the distribution. The IRS has ruled...