Taxation of Distributions
Tax Management Techniques
As a general rule, it is best to allow the plan assets to grow tax-deferred as long as possible. However, IRS regulations require that for most retirement plans, eventually distributions in minimum amounts must begin, in most cases, after the plan participant reaches the age of 70.5. An exception to the RMD rules are Roth IRAs, Roth 401(k)s and other types of Roths.
A suggested order of withdrawal in order to take maximum advantage of tax deferral:
- Taxable Accounts – Long-term capital gains in a taxable account are taxed at the lower capital gains rate, as opposed to the higher ordinary income rates.
- Tax-Deferred Accounts with RMD requirements.
- Roth Accounts – Since no RMDs are required, the owner of a Roth account should allow these assets to grow tax deferred as long as possible.
Exception to RMD Rules – Participants in qualified plans, 403(b) and 457 plans may delay distributions if they continue working past the age of 70.5 for the plan sponsor. This exception does not apply to more than a 5% owner of a company. Also, individual plan rules may require participants to begin distributions after reaching the age of 70.5 even if they continue to work. The exception does not apply to traditional IRAs or to plans sponsored by past employers.
Net Unrealized Appreciation
This is the difference in value between the average cost basis of shares and the current market value of the shares held in a tax-deferred account. The net unrealized appreciation (NUA) is important if you are distributing highly appreciated company stock from your tax-deferred employee-sponsored retirement plan, such as a 401(k). Upon the distribution, the NUA is not subject to ordinary income tax. For this reason, it may be better to transfer the company stock to a regular brokerage account instead of rolling the stock over to a tax-deferred IRA: that is, if rolled over to an IRA, the company stock's NUA would eventually be taxed at your ordinary income tax rate (when you take the distribution of the stocks).
However, the other assets in the 401(k) - such as mutual funds - do not receive the NUA tax break. So, plan participants would still likely want to roll these plan assets into an IRA and continue deferring taxes on past and future growth. Also, when an individual takes advantage of the NUA tax break for your company stock (by not rolling it over into an IRA), they will not have to worry about taking RMDs on those assets since they are not part of an IRA.
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