Ed Slott: Why a Lump Sum Beats an IRA Rollover for Some Clients

While an IRA rollover is the best move for most people when distributing money from a 401(k) plan, there is a special case when a lump-sum distribution makes sense — and the justification for one is "bigger than ever," according to tax and IRA expert Ed Slott of Ed Slott & Co.

On a recent video chat with Morningstar's Christine Benz about the Labor Department's new fiduciary rule, Slott relayed that Labor is attempting to prevent advisors from making a "knee-jerk default to the IRA rollover because they will do better with that because they have assets under management they get paid on."

Labor, Slott said, wants advisors to get educated on each option for an old 401(k) and to have a process in place to explain the best of three options for distributing the assets in the plan.

The three choices, Slott explained, are "roll it over to an IRA, leave it in the company plan, or if you get a new job, roll it to a new company's plan — but it's essentially the same thing because it stays within a 401(k) — or take a lump-sum distribution and pay the tax."

Why would you leave money in a company plan? "Generally, that's not the best move; the IRA rollover is the best move for most people," Slott said.

Labor, Slott continued, wants advisors to communicate with the employee that has a 401(k) the pros and cons of each option.

Slott counsels advisors to tell clients, "You have the IRA rollover. That's generally the best," he said. "If you don't see advantages in the other two, by default, that's probably the best option."

When a Lump Sum Makes Sense

Benz noted during the video that the lump-sum distribution option, or take "the money and run option … should be marked with a skull and crossbones, like don't ever do it."

Slott responded, however, that there is a reason to take a lump sum, "and it's bigger than ever."

The lump-sum distribution is where advisors tend to not know enough, according to Slott.

"With a tax break in employer securities called net unrealized appreciation, you can turn what otherwise would be ordinary income rates — because if you take money out of an IRA, it's regular job income, ordinary income," Slott said. "This turns that same income, if you qualify, to long-term capital gain rates, which can be half, if you know about it."

Who qualifies for this?

Advisors, Slott said, need to ask clients two questions: First, does the client have company stock in their plan?

"Most people do," Slott said. "You work for IBM, they probably have been piling on IBM stock or whatever company you're working for. It's a common thing, a common thing that people do, they invest where they work."

Second: Is it highly appreciated?

"This is where it's a big thing again now because the market has run up like crazy," Slott said. "Longevity on the job. You've been at a job in some of these big tech companies, for example, for 20 or 30 years …."

For instance, Slott continued, "Let's say you have Apple stock, a million dollars' worth, but over the years you only paid $100,000 for it when you put it in the plan. That difference between a million and the $100,000 cost is called net unrealized appreciation, or what we call NUA, in employer securities."

If the client qualifies for a lump-sum distribution — and there are four qualifiers — the client could roll the other noncompany stock assets over to their IRA, and that would leave just the million dollars of this Apple stock, Slott said. "But it has to be a lump-sum distribution. So, the plan has to happen in one calendar year after what we call a triggering or qualifying event, that's age 59.5 or separation from service."

The other qualifiers are death and disability.

"If you take the stock down, that would empty the account because the other funds from the 401(k) were rolled over," Slott continued.

"You take it. You don't sell the stock. That's one of the mistakes — people blow it. You take the stock out in-kind as stock and transfer it to a taxable account, that million dollars, you only pay tax on the cost, $100,000, that original cost. That other $900,000 comes over to your taxable account absolutely tax-free. And whenever you do take that money out, you sell the stock, you automatically get long-term capital gain rates."

Added Slott: "So, this applies to a lot more people because more people have company stock, longevity at the job, and the market runup. Now any advisor that doesn't ask that question may have really blown it."