The following is a hypothetical example based on the conversations I’ve had with people over nearly 27 years (19 as a practicing CFP®) that have large amounts of company stock in a retirement plan – usually an ESOP or 401(k).
Many of the calls we get in our office are from people who are trying to decide if they should roll their company stock into an IRA in order to defer taxes on their distribution, or simply take their distribution in-kind as stock bypassing an IRA, and then take advantage of something called Net Unrealized Appreciation (NUA) tax rules.
Before we dive in, please understand that I’m not a fan of, “the tax tail wagging the dog”. In other words, allowing taxes to be the primary driver of a financial decision. In this case, however, the decision of where to move and hold company shares after they’ve been distributed from a retirement plan IS primarily a tax decision.
Why? Because the company stock remains company stock regardless of where it is held. When you take your distribution, if you decide to simply hold the stock, you’re changing the “address” of those shares - and whether they are in a tax-qualified plan such as an IRA or not.
To be fair, in certain cases, rolling a portion of your stock into an IRA might make sense (see advantages and disadvantages below). However, for stock you intend to keep indefinitely - and perhaps pass on to heirs - the taxes you defer by using an IRA will most likely create a significantly higher tax liability for you - and for your heirs - when mandatory distributions are finally made from the IRA.
The following is an example of the potential long-term tax implications of rolling your stock into an IRA and holding it in the IRA rather than taking a lump-sum, in-kind distribution of those shares and holding them outside of an IRA.
LPL Financial and Crossover Point Advisors does not provide legal advice or tax services. Always consult your own legal and tax advisors regarding investment and tax strategies tailored to your situation.
Case Study
It’s been said that farmers would rather pay taxes on the seed when possible - and not the crop. I’m not a farmer, but it seems to make sense to me.
Let’s start by defining the terms Seed and Crop and how they apply to the distribution of company stock from retirement plans.
- The “seed” is the Cost Basis of the shares, i.e., the amount you or your company paid for the shares.
- The “crop” is the amount those shares are worth when you retire minus the cost basis. This is also known as the Net Unrealized Appreciation or NUA.
As an example, let’s say you retire from your company with $2 million in stock in your ESOP which costs you or the company $150,000 to purchase. These will be the figures we use as an example in this study.
Rolling your shares into an IRA - Taxes on the Crop
The following is an example of the potential long-term tax implications of rolling your stock into an IRA and holding it there and would be an example of deferring taxes on the SEED but then paying taxes later on the CROP.
For the purposes of this study, let’s assume a 73-year-old recently lost her husband and inherited his IRA. She has one adult son who stands to inherit what’s left of the IRA at her death. We’ll call her Jane and the son John.
Let’s also assume her late husband - seeking to avoid immediate taxation of the distribution - rolled over the stock from his ESOP into an IRA 14 years ago - and let’s assume it was valued at $2 million at that time.
Fast forward to 2025 and the stock in the IRA based on an assumed growth rate of approximately 8% is now approximately $5.7 million. Impressive, but it presents Jane with a tax dilemma.
Required Minimum Distributions – RMD’s
Under current tax law, since Jane is 73, with few exceptions, she must begin taking Required Minimum Distributions (or RMD’s) from the IRA - even if she doesn’t need the money. At $5.7 million, this would require a first-year distribution of approximately $200,000 and this amount is fully taxable and would be added to her other income.
If the shares continue to grow at 8% per year over the next 10 years (to her age 82), her taxable distributions will continue to rise. If the value of the shares were to go down, the mandatory amount would be reduced, but she would still need to take the distribution.
Based on an 8% average annual rate of return and using IRS Uniform Life Table over the next 10 years, Jane could expect to take approximately $2.8 million in mandatory distributions! If her effective tax rate was 25%, that would be approximately $700,000 in taxes over 10 years.
Implications for the Inheritor
Let’s assume Jane passes away at age 83, and her son John inherits the IRA now worth approximately $6.6 million. But there are significant differences between and spouse and a non-spouse beneficiary when inheriting an IRA.
As a non-spouse beneficiary, under current tax law, even if John is under the mandatory distribution age, he must continue taking annual distributions because his mother was taking them when she died. AND he must fully distribute the IRA within 10 years of Jane’s passing. This is likely to cause high and rapidly increasing tax liability due to large, required distributions added to his personal income.
Assuming shares continue to grow at 8% per year over the next 10 years, John would have mandatory distributions of approximately $11.6 million including $7 million in just the last year! Assuming a 37% tax bracket, this would result in approximately $4 million in taxes on shares that they are not selling but simply repositioning from an IRA to a Non-IRA.
Keep in mind there are advantages and disadvantages to any financial strategy. Here are some that apply to rolling corporate stock into an IRA.
Advantages
- Taxes deferred upon distribution
- Taxes on growth and dividends deferred
- Protected from creditors in FL (state specific)
- Taxes are deferred on realized gains
- Taxes are deferred if stock is sold and diversified
- Taxes are deferred when new investments are bought and sold
Disadvantages
- Taxes on distributions potentially much higher
- Potential 10% penalty on distributions prior to age 59½
- Forfeiture of Net Unrealized Appreciation (NUA) tax treatment
- 10 yr mandatory distribution to non-spouse heirs
- Required Minimum Distributions (RMD’s) starting between ages 73 &75.
- Mandatory distributions likely result in taxable income
- IRA custodian necessary which may result in fees.
These calculated RMD figures illustrate how holding large balances of appreciated company stock in an IRA can create rapidly intensified tax burdens for retirees and their heirs under current distribution rules. Always consult current IRS tables and a qualified professional for tailored calculations, as law and individual scenarios may vary.
The NUA Approach – No IRA – Taxes on the “Seed”
Had Jane and her late husband chosen a different distribution strategy, they might have paid substantially less in Federal Income Taxes. Let’s look at a hypothetical example.
Let’s assume:
- In 2011, Jane and her husband intended to hold the shares indefinitely and live off the dividends
- They took an in-kind, lump-sum distribution of approximately $2 million of company stock from the husband’s ESOP and received a certificate rather than rolling it into an IRA.
- 14 years later, at an average annual return of 8%, the shares have now grown to approximately $5.7 million
- Husband passes away and now the shares belong to Jane.
- They continue to grow at 8% per year over the next 10 years.
- Their cost basis - or the average amount paid for the stock by either themselves or the company – equals approximately $150,000.
It’s 2011 and our examples decide to simply take a full, in-kind, lump-sum distribution of all their shares in certificate form. Their taxable amount would be $150,000 and added to their income in the year it was received. This is the “the seed”, i.e., the money used by their company to purchase the shares.
The rest – or $1,850,000 – is what is known as Net Unrealized Appreciation or NUA. This is the “crop” the seed grew into. But the crop it considered an “unrealized gain,” and because the gains aren’t considered real by the IRS, there are no taxes owed immediately on the NUA after the initial distribution.
Only the cost basis is reported as the “taxable amount” at distribution because the shares were purchased with dollars that had never been taxed (pre-tax dollars).
Since the cost of $150,000 is now going to show as ordinary income, let’s assume their tax liability is 25% of that amount - or $35,000. While that may be hard to swallow for some, it may be easier if you realized the alternative would be somewhere around $4 million mentioned prior.
Back to Jane. Using these assumptions, if Jane and her husband had used the NUA strategy and taken their stock as a certificate without using an IRA, here’s the approximate result:
- $35,000 in upfront taxes in 2011 - vs a potential $4 million dollars over the next 20 years.
- No mandatory distributions for either Jane or John thereafter – if they don’t need it, they can leave it.
- If the shares are never sold, there would be no additional taxation - except on dividends.
- From 2017 on, dividends would have been taxed at more favorable capital gains rates of 0% 15% & 20% - vs taxes on dividends coming from the IRA that would be taxed at higher ordinary income tax rates.
- If the value of the stock is under the Federal Estate Tax Exemption amount when the last shareholder dies, the stock would pass on tax free to heirs and the gains (NUA) would not be subject to taxation unless the shares were sold.
- No mandatory distributions for any of the heirs (under current tax law).
Below are some of the advantages and disadvantages of implementing this strategy - not rolling distribution into an IRA - and again, I’ve written about it extensively on our website.
Advantages
- Taxes overall are potentially lower
- NO forced distributions to non-spouse heirs
- 10% penalty applies only to cost basis
- May pass on to heirs initially tax free
- NUA Treatment of gains apply
- NO Required Minimum Distributions (RMD’s)
- No IRA custodian or associated fees
Disadvantages
- Portion (cost basis) taxed at distribution
- Taxed if and when diversified
- Realized Gains potentially taxable if shares are sold
- Taxed when portfolio is trades are placed if gains are realized
- May not be protected from creditors in certain states
Conclusion: No strategy is perfect for everyone, and this is no exception. When you retire, the decision of how and where to move the company stock you want to hold can have lasting implications for personal and generational tax liability. We recommend before executing any distribution strategy, you should consider your personal circumstances and consult with a tax advisor who is familiar with the advantages and disadvantages of both options. As always, we’re here to help.
Crossover Point Advisors™ and LPL Financial do not provide legal advice or tax services. Please consult your legal advisor or tax advisor regarding your specific situation. The examples provided in this piece are case studies and are hypothetical situations based on real life examples in which the names and circumstances have been changed. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your advisor prior to investing. Investing involves risk including the loss of principal. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes.