Timing Your RMDs and Saving Taxes With NUA

Hi, Gail-
In a recent column you explained how to calculate your “required minimum distribution” from an IRA. I’ve got several different kinds of IRAs -- a regular one with tax-deductible contributions, a Roth, and a SEP IRA which is my retirement plan from my last employer.

I turned 70½ in September (my birthday is in March), so I have to start withdrawing the minimum amount from my IRAs by the end of this year. Does that include all of these?

Thanks,
Jeff

Dear Jeff-
You’re smart to be planning this move now because sometimes it takes longer than you might expect for an IRA custodian to process the paperwork and the federal penalty for not taking a required minimum distribution (RMD) by the year-end deadline is severe: 50 percent!

However, because this will be your first RMD, you’ve got some extra time -- until April 1 of the year after you turn 70½. In your case, this would be April 1, 2007. After that, subsequent RMDs -- including the one you will have to take next year -- must be completed by December 31 of that year.

While it may be tempting to postpone your first RMD as long as possible, this isn’t always smart. If you wait until next year to withdraw this money, you’ll end up having to take two RMDs -- the one for 2006 and the one for 2007 -- in a single year. Depending upon your tax situation, bunching up this income could throw you into a higher tax bracket. I suggest you ask your tax advisor to see which would be the best strategy.

Since I covered how to calculate your required minimum distribution in a previous column, I won’t repeat that here. However, the rule is that you must take an RMD from all IRAs except a Roth. This includes IRA accounts that were part of an employer retirement plan such as your SEP IRA or a SIMPLE IRA.

However, you don’t have to withdraw an RMD from each account -- you can take the whole amount from a single IRA or any combination.

For instance, suppose you figure that the RMD from your traditional IRA is $5,000 and the RMD from your SEP IRA is $12,000. You can withdraw those amounts from the associated accounts, or you can take the entire $17,000 distribution out of your regular IRA.

One reason you might want to do this is to maintain a particular asset allocation. Or perhaps your traditional IRA account is relatively small and you’d like to eliminate it and the annual custodial fee you’re paying.

No matter how old you are, you never have to take required minimum distributions from your Roth IRA*. That’s because the IRS has already collected its money on your contributions since these were made with after-tax money. The advantage to a Roth, of course, is that the growth of your contributions forever escapes federal income tax.

For many people, it makes sense to tap Roth IRA assets last. That’s because the longer you can leave your money in your Roth account, the greater the potential for it to grow thanks to tax-free compounding.

Hope this helps,
Gail

*Be careful: if you inherit a Roth IRA and are not the spouse of the IRA owner, then RMDs are required. That’s because as a non-spouse beneficiary, you cannot roll an IRA into your own name, i.e. you cannot become the “owner” of the IRA. A non-spouse beneficiary of an IRA – traditional or Roth -- must either take required minimum distributions over his/her life expectancy or else empty the account within 5 years.

Gail-
When I retired I had both mutual funds and stock from my employer in my 401(k). On the advice of my financial advisor, I rolled over the mutual funds into an IRA, but moved the stock into a regular brokerage account. It was worth about $80,000, but I only had to pay tax on what it actually cost me: $20,000.

I understand that if I sell this stock, then I’ll have to pay tax on the difference -- $60,000. But this will save me a bundle because it will be at the long term capital gains tax rate, which is a lot lower than my 35 percent income tax bracket.

Here’s what I’d like to know: If I don’t sell this stock and my kids inherit it, they’ll get a “step-up” in the value. Does this mean that all of the appreciation in this stock will escape tax?

(I know this sounds too good to be true, but I thought I’d ask.)

Thanks,
Barb

Dear Barb-
Your instincts are correct: Your kids will not receive a “step-up” in cost basis on all of the appreciation in your company stock when they inherit it.

The strategy you’ve employed comes under the heading of “Net Unrealized Appreciation” (NUA) in the tax code. It gives a special tax break to folks who have employer stock in a retirement account.

In general, all assets in a retirement plan that were bought using pre-tax money are eventually subject to income tax when they are withdrawn. Employer stock is an exception, provided you do this correctly. The requirements are very specific, so I’m glad you’re working with a financial advisor.

Under the NUA rules an eligible employee can withdraw employer stock from their account in the company plan and only pay ordinary income tax on the cost basis, i.e. what they actually paid for the shares when they bought them through the plan. In your case, this amounts to $20,000. (Your employer is required to keep a record of the average cost.)

The difference between what you paid for these shares and what they are worth when you move them from your company retirement plan to a brokerage account is called the “unrealized appreciation.” It’s the difference between what the stock is worth today compared to what you paid for it. The NUA amount in your example would be $60,000 ($80,000 minus $20,000).

When the stock is sold, in IRS-speak the appreciation is “realized.” However, instead of paying ordinary income tax on the $60,000 gain, your profit is taxed at the potentially much lower long-term capital gains rate, currently a maximum of 15 percent.

If you still own these shares at the time of your death, the tax due on the $60,000 unrealized appreciation does not disappear. It’s simply postponed until your beneficiary sells the stock. Your children would, however, get a “step-up” in value for any appreciation over and above that amount.

For instance, say the employer stock is sitting in your brokerage account when you die. Over the years it has continued to appreciate in value and now is worth $100,000. Your kids inherit it and want the money.

They would owe $9,000 in long-term capital gains tax on the NUA portion ($60,000 x 15 percent). However, the additional appreciation above the NUA value would be eligible for a step-up in cost basis. Thus, assuming they sold the stock for $100,000, they would not owe any tax on the additional $20,000 the stock is now worth.

Hope this clears things up,
Gail

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.