Which is best?
Strategy: Opt for the payout in company stock. Thanks to a giant loophole in the tax law, you only have to pay current federal income tax on 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. As 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 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 million when you retire. But the entire payout is taxed as ordinary income.
That means, assuming you’re in the 35 percent tax bracket in the year of retirement, the federal income tax bill is a hefty $350,000. (You may qualify for special 10- year averaging on a lump-sum distribution from the plan, 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 $100,000 cost. (20,000 shares at $5 a share). So, your current federal income tax bill is $35,000 (35 percent times $100,000).
Then, you immediately turn around and sell the stock at $50 a share. That gives you a total of $1 million (20,000 shares times $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 times $900,000).
By using this approach, you save a whopping $180,000 in tax on your retirement plan payout ($350,000 compared to $170,000 ($35,000 plus $135,000).
Congress keeps threatening to do away with the tax loophole, but so far, no dice. 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 over the course of time as you receive distributions, 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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