A DEFINITIVE METHOD TO DETERMINE IF A COMPANY IS CONFORMING TO 404(C) STANDARDS

This exercise relates only to those large employers who offer employer stock as part of their 401(k) or other tax deferred programs. This financial/tax/retirement/estate planning scenario MUST be taught to every employee since it is fundamental to their decision making process once retired. If not, it, in my mind, conclusively shows a major deficiency in the educational requirements of 404(c) regulations and quite probably extends the liability of an employer for any excess taxes paid by the employee or beneficiary.

It involves the unique tax aspect to the use of employer stock in a tax deferred account. However, in order to properly explain the issue it is necessary once again to address TAX BASIS. The link takes you directly to the tax page but I will try to briefly explain it here.

With pure tax deferred pension plans, all assets within the account have never been taxed. If you take the assets out- or even if you roll them to an IRA- any subsequent distribution is taxed as ordinary income. And even if you left them to beneficiaries at death, they are still taxed as ordinary income.

If you had other type of assets in a regular (non tax deferred account)- say a mutual fund- and you sell the assets, any gain above your initial purchase (plus dividends and capital gains) are taxed as long term capital gains at a current maximum of 28%. Further, if your were to leave the assets to your beneficiaries, they get a full step up in basis at that point and they would owe NO tax on a sale at that time.

But the issue here is a caveat in both tax positions allowed by IRS ruling 75-125.

First the bad part. If you have employer stock in a plan and roll it to an IRA, you encounter the worst tax situations as identified above- ordinary income for both a sale by yourself or if left to beneficiaries and they sell it later.

Next is the unique features of employer stock which is best identified by example.

Assume employer stock was contributed to your plan at $10.00 a share. Over the next few years, it increased to $50.00. If you retired and rolled the stock to your IRA to continue your tax deferral, any subsequent removal of the shares and a sale would result in ordinary income taxation on ALL the proceeds.

But in the event you would take out the stock intact from the plan, this is what will happen. You will have to pay ordinary income tax on the value of the shares when they were initially put into the plan ($10.00). The other $40.00 increase is NOT taxed until and if you subsequently sold the stock. And the it would be taxed as LONG TERM CAPITAL GAIN. Assuming the stock continued to rise to $70 before a sale, a subsequent sale would result in a $60 long term capital gain ($70.00- $10.00 tax basis).

The unique aspect is if you leave the stock to a beneficiary at death. We'll first assume the stock was no higher than the $50.00 value at retirement. The beneficiary gets a partial step up in basis for the $10.00 of "cost basis" that had already been taxed. The $40.00 remains as long term capital gain to the beneficiary- it does not get a further step up at death. Nonetheless, the tax costs usually are less than ordinary income- unless one is in a low tax bracket..

Lastly, we'll assume the stock increased to $70.00 when the owner died. The beneficiary gets a step up in basis for the $10.00 as stated above PLUS the $20.00 of gain AFTER the stock was taken out= total $30.00. The $40.00 of appreciation while in the pension plan retains it long term capital gains characteristics. IT IS NOT STEPPED UP.

This is a major issue for all retirees that have employer stock in a plan and the tax ramifications MUST BE TAUGHT TO EMPLOYEES PRIOR TO RETIREMENT AND CERTAINLY AS PART OF 401(K) EDUCATION. This is a key and critical area to an employees financial and retirement planning.