401(k) Encore

By Daniel Kadlec

Two things are clear from the deluge of mail I've received since my "Retirement Tricks" column ran several weeks ago: 1) a whole lot of people are sitting on a whole lot of highly appreciated employer stock in their 401(k) plans, and 2) despite a fair amount of press, confusion reigns concerning an IRS rule that permits people who retire or switch jobs to take possession of their company stock rather than roll it into an IRA.

Taking possession of employer shares can cut your tax bill. When you eventually sell, the profit is taxed as a capital gain at 20% for most people. An IRA distribution, on the other hand, is taxed as income--at up to 39.6%. Basic math, gang. Here are questions from my mail and answers, with an assist from Ed Slott, editor of Ed Slott's IRA Advisor. Ed has more on his website at irahelp.com To read my earlier column, see time.com/personal

Does it matter whether my stock is part of an employer-match program, or can I also include the shares bought with my own contributions?

Both qualify. But if you bought employer stock with after-tax contributions, those shares should be separated to avoid double taxation.

Does it matter if my employer stock is held in a fund? No, unless that fund also holds other securities. Most big plans hold company stock in a fund whose only assets are that stock. Don't be confused by the word fund. It's simply a holding tank. Those shares are eligible.

Can I transfer 401(k) assets into employer stock shortly before leaving and then take possession of the whole bundle?

Yes. But it probably won't help. The key to tax savings is the net unrealized appreciation of employer stock--or how much the stock has risen. The current value should be at least double--and probably three or four times--the cost basis of the shares for the strategy to make sense. When you transfer assets at the last minute, you drive up the cost basis big time. In rare cases, though, in which a stock has really soared, the cost basis may remain low enough for that to work.

What tax forms do I need?

IRS Form 4972, for lump-sum distributions. You will receive Form 1099 from your plan administrator, showing a distribution that is exempt from the automatic 20% tax withholding. Make sure it's right.

Where are these rules in the IRS code?

Section 402(e)(4). What if the company stock in my plan has been there less than a year?

You'll pay income tax on the cost basis, but the gain will be treated as long term no matter when the stock was bought.

If I leave my job before age 55, I must pay a 10% penalty on any 401(k) distribution, including any "in-kind" distribution of employer stock. How does that affect the strategy?

It still works, depending on the stock's appreciation. If you have $500,000 in stock with a cost basis of $50,000, for example, it's a lock. The penalty applies only to the cost basis, in this case amounting to $5,000.

Is there any way to avoid the immediate tax triggered by taking possession?

Nope. You'll owe immediate income tax on the cost of every share you take out. It would be great if you could take possession of just the gain and roll the cost into an IRA. But that's like splitting an atom--an unnatural divide with explosive consequences.

See time.com/personal for more on 401(k). E-mail Dan at [email protected] See Dan Tuesdays on CNNfn at 12:45 p.m. E.T.