Which is better?
Strategy: Opt for the payout in company stock. Thanks to a giant loophole in the tax law, you have to pay current federal income tax on only the plan’s original cost of the stock. In other words, any appreciation in value is 100 percent tax-free until you actually sell the shares!
But that’s not the end of the story. If you sell the stock down the road, you’re required to pay capital gains tax on the difference between the sales price and the original cost. So long as you meet the holding period for long-term capital gain, the maximum federal tax rate is no more than 15 percent.
So, you’ll end up being a double tax winner: once when you leave the company and once when you sell the stock.
Example: taking a stock payout
As the founder of a successful business, you’ve salted away 20,000 shares of company stock in your retirement plan. The shares are currently valued at $1 million. The stock originally was $5 a share, and now it’s worth $50 a share.
If you take the traditional approach—having your account sell the stock and taking a cash payout— you’ll receive a cool $1 million when you retire. But the entire payout is taxable as ordinary income.
Assuming you’re in the 35 percent tax bracket in the year you retire, you’ll pay a hefty $350,000 in federal income tax. (Note: You may qualify for special 10-year averaging on a lump-sum distribution from the plan, only if you were born before 1936.)
Now, let’s see what happens if you take a distribution in the form of company stock.
You have to pay tax at ordinary income rates on the original cost of $100,000 (20,000 shares at $5 a share). So, your current federal income tax bill is $35,000 (35 percent of $100,000).
Then, you immediately sell the stock at $50 a share for a total of $1 million (20,000 shares at $50 a share).
With the 15 percent capital gains rate, your tax bill on the previously untaxed appreciation of $900,000 is $135,000 (15 percent of $900,000).
By using this approach, you save a whopping $180,000 in tax on your retirement plan payout: $170,000 ($35,000 plus $135,000) compared to $350,000.
Congress keeps threatening to kill the loophole, but so far has not. Still, if tax revision begins to pick up steam, you might decide to retire sooner rather than later.
Tip: Alternatively, you can roll over the distribution into an IRA. That allows you to spread out the tax as you receive distributions over the course of time, but you’re still taxed at ordinary-income rates. In the usual situation, your highest marginal tax rate in retirement will be lower than your current rate.
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