Thomas Edison once said, "To invent, you need a good imagination and a pile of junk."
Given the options that executives have today with regard to their retirement plans, there certainly is no shortage of the latter. The challenge then is to use existing retirement rollover rules as the basis for the development of truly useful solutions.
One rule in particular could be helpful as you work with executives in this area. Well look at that rule here.
Most executives are presented with no more than two retirement options: 1) roll their existing plan assets over to a traditional Individual Retirement Account; or 2) roll over to a Roth IRA (by rolling to a traditional IRA and then immediately converting to a Roth IRA). Lets look at these:
Option One: As you know, by rolling to a traditional IRA, the executive incurs no tax on the rollover but must pay taxes on all subsequent withdrawals at ordinary income tax rates. In addition, minimum distribution rules apply, and the entire IRA is subject to both income and estate taxation at death.
Option Two: If eligible, an executive may instead choose to roll over to a Roth IRA. This will trigger an immediate tax on the conversion amount at ordinary income tax rates, but will allow earnings not only to accrue without taxation, but also to be withdrawn tax-free. Moreover, the Roth IRA is not considered Income in Respect of a Decedent (IRD), so heirs can inherit the plan income tax (though not estate tax) free.
The choice, when available, boils down to paying income taxes on the entire plan up-front, or paying income taxes on the entire plan at the back end.
By choosing to pay sooner, the taxpayer writes a smaller check to the government, but has that much less available to accumulate on a tax-deferred basis. Also, neither rollover option avoids the payment of taxes at ordinary income tax rates. Neither protects against estate taxation. Neither insulates the underlying stock investments from market risk. And neither allows cherished employer stock to be passed to heirs intact.
Now for a solution. Employer stock distributions offer a more tax-efficient alternative to IRA rollovers. Under Internal Revenue Code Section 402(e)(4), when an employee receives a lump sum distribution of securities of the employer corporation, the employee need only pay income taxes on the employers cost basis of the stock.
This cost basis is often significantly less than the fully appreciated value at time of distribution. The difference, or Net Unrealized Appreciation, is not included in gross income. Hence, your executive client receives outright ownership of the shares with a cost basis equal to the employers original stock basis.
