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Saturday, April 27, 2024
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Case Studies |
A 401(k) Rollover to a CRT
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Case:
Jackie Judson, age 60, has worked for the same company for over 30 years. Back when she began as an employee with this company, a 401(k) plan was established to provide for her retirement. The 401(k) is invested exclusively in the company stock, which has appreciated substantially over the years. In fact, based upon the number of shares in her 401(k) and the current fair market value of the company stock, the plan is currently valued at $1,000,000. Jackie is considering retiring and is quite concerned that the plan is invested entirely in one stock. She has read many times in financial planning publications that there are three key ingredients to investments - diversify, diversify and diversify. Also, she is interested in making a current gift of $50,000 to one of her favorite charities and a planned gift, possibly through a charitable remainder unitrust.
Jackie is concerned about taking withdrawals from her 401(k) plan because of the tax consequences. In a recent meeting, her CPA, Kevin Frazier, summarized the ins and outs of withdrawals from qualified retirement plans for her. He stated that under current IRS law, most withdrawals from qualified plans are subject to ordinary income tax in the year of withdrawal. However, the IRS makes an exception for certain in-kind distributions of employer securities held in a qualified workplace savings plan, such as a 401(k). (With an in-kind distribution, the employee receives unsold stock certificates directly from the employer.) Under the IRS exception, if the employee takes the company stock in an in-kind, lump sum distribution, he or she will owe only the income tax on the original cost of the stock. In other words, the IRS allows the employee to postpone paying tax on the net unrealized appreciation - that is, the difference between the stock price when the initial investment was made and its appreciated value today - until the stock is sold. At the time of the sale, the employee will owe capital gains tax as opposed to the ordinary income tax.
Question:
Jackie currently has 10,000 shares of company stock inside her 401(k) plan. Her average cost basis in these shares is only $25 and the current per share price is $105. Therefore, the total value of her plan is $1,050,000. As stated above, she wants to make a current contribution of $50,000 to fulfill a pledge she made to a capital campaign. She would then consider using the majority of the 401(k) to fund a charitable remainder trust. However, Jackie wants to minimize the tax bite. She has heard that you cannot roll over a traditional retirement plan into a charitable trust without onerous tax consequences. Is there some way to accomplish her objectives using the 401(k) plan?
Solution:
Kevin stated that, in fact, there is a very tax-efficient way of utilizing Jackie's 401(k) to fulfill these objectives. If Jackie decides to retire, she can take the stock from the plan in an in-kind, lump sum distribution. As a result, she will owe income tax on $250,000, which represents her average cost basis in the shares (10,000 x $25). The other $800,000 of value will be taxed at the long term capital gain rate if and when she decides to sell the shares. Instead of selling the stock, Jackie can transfer a portion of those shares into a charitable remainder trust which will, in turn, sell the stock, thereby bypassing capital gains taxes. If she transfers shares values at $1,000,000 to a 7% unitrust for her life, her charitable income tax deduction will be $296,190. The other shares valued at $50,000, can be contributed to charity outright to fulfill her campaign pledge. Once again, the capital gains taxes on these particular shares will be bypassed.
Jackie is pleased with this plan for a number of reasons. First of all, even though she is required to report the $250,000 in ordinary income, she has tax deductions totaling $346,190 that can be used to help offset the income tax bite this year. Kevin stated that she can write off only approximately $100,000 of those deductions this year because of adjusted gross income limitations, but she will be able to carry forward the excess contributions for up to five years. Second, because the unitrust is able to sell the stock and bypass capital gains, the trust can diversify its portfolio. Third, Jackie's retirement income from the trust will be $70,000 per year, which will continue to increase, assuming the trust earnings exceed 7%. Lastly, assuming that the trust's net total return is 8%, over $1.2 million will pass to charity at her 24-year life expectancy - a nice gift indeed!
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