Tax Connections Newsletter – Fall 2019
Robert Swenson

Take It or Leave It? How to Handle Your 401(k) Plan When You Retire

If you are newly retired, or planning to retire soon, you will need to decide what to do with the savings you have accumulated in your company’s 401(k) plan. If you don’t need to tap the funds right away, it is generally best to let them continue earning investment income on a tax-deferred basis for as long as possible. But should you leave the funds in your employer’s plan or roll them over into an IRA? As long as your account balance is $5,000 or more, you are permitted to keep your money in a former employer’s plan.

Following are some of the factors to consider in making this decision. The discussion assumes that you have a traditional 401(k) plan account. If you have a Roth 401(k) account, different considerations may come into play.

Investment options

IRAs offer a wider selection of investment options than 401(k) plans. Even if your company has carefully selected a menu of high-quality investments, your choices will likely be limited to 20 or 30 funds, while IRA owners may choose from among thousands of funds and individual securities. This makes it easier to build a well-diversified portfolio with an asset mix that is appropriate for your financial needs, risk tolerance and time horizon.

Related Read: “Should You Convert Your Balance to a Roth IRA?

Fees and costs

Both 401(k) plans and IRAs generate fees and investment costs and, because they come out of your returns, they are easy to overlook. But these expenses can have a significant impact on the performance of your retirement funds, so do your homework. Often, it is possible to find an IRA with lower fees than your 401(k) plan, but in some cases it may be cheaper to leave your money in the plan.

Your age

Ordinarily, if you withdraw money from a 401(k) plan or IRA before age 59-½, you will owe a 10% penalty (in addition to taxes at your ordinary income tax rate). There is an exception, however, that allows you to take penalty-free withdrawals from your former employer’s 401(k) plan if you retire or otherwise leave your job when you are 55 or older. If you will need to withdraw funds before you reach age 59-½, it may be better to leave them in your 401(k).

Your work plans

If you are approaching age 70-½, consider the impact of required minimum distributions (RMDs). Normally, you must begin taking taxable RMDs from 401(k) plans or IRAs when you reach that age. But suppose you are taking partial or phased retirement and will continue working for your employer part-time past age 70½. Some 401(k) plans allow you to postpone RMDs until the year you fully retire, so it may make sense to leave your money in the plan.

Related Read: “The ‘Backdoor’ Roth IRA Strategy

Company stock

If your 401(k) plan invests in the sponsoring employer’s stock, consider the tax consequences of a rollover. If you roll over the entire balance into an IRA, future withdrawals will be taxed at ordinary income tax rates. But, if you leave the funds in your 401(k), you may have an opportunity to take advantage of favorable long-term capital gains tax rates.

Special rules allow you to spin off the company stock into a taxable account. (The remaining balance can then be rolled over into an IRA.) You will immediately owe ordinary income taxes on the stock’s tax basis. However, all past and future appreciation will be treated as long-term capital gain when you sell the stock. Whether this strategy is right for you depends on the amount of appreciation, your tax bracket and your ability to pay the initial tax bill.

Take your time

When you retire or otherwise leave a job, there is no need to immediately withdraw your 401(k) plan funds. Take the time to review your options and consult your tax advisor before taking action.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.

© 2019

Tax Implications of Equity-Based Compensation

Equity-based compensation is a powerful tool for attracting, retaining and motivating executives and other employees. By rewarding recipients for their contributions to your success, it aligns their interests with those of the company and provides them with an incentive to stay. Here is a look at some of the more common types.

Incentive stock options

Stock options confer the right to buy a certain number of shares at a fixed price for a specified time period. Typically, they are subject to a vesting schedule. This requires recipients to stay with the company for a certain amount of time or meet certain performance goals to enjoy their benefits.

Incentive stock options (ISOs) offer attractive tax advantages for employees. Unlike non-qualified stock options (NQSOs), ISOs do not generate taxable compensation when they are exercised; the employee is not taxed until the shares are sold. And if the sale is a “qualifying disposition,” 100% of the stock’s appreciation is treated as capital gain and is free from payroll taxes.

To qualify, options must meet several requirements, including the following:

  • They must be granted under a written plan that is approved by the shareholders within one year before or after adoption;
  • The exercise price must be at least the stock’s fair market value (FMV) on the grant date (110% of FMV for more than 10% shareholders);
  • The term cannot exceed 10 years (five years for more than 10% shareholders);
  • They cannot be granted to non-employees;
  • Employees cannot sell the shares sooner than one year after the options are exercised or two years after the options are granted; and
  • The total FMV of stock options that first become exercisable by an employee in a calendar year cannot exceed $100,000.

Although the benefits are substantial, ISOs also have drawbacks. Unlike NQSOs, qualifying ISOs do not generate tax deductions for the employer. In addition, there is a potentially significant tax risk for recipients. Employees subject to alternative minimum tax (AMT) — or whose exercise of ISOs triggers AMT — must pay tax on the spread between the exercise price and the stock’s FMV on the exercise date, regardless of when they sell the stock. In other words, they are taxed on profits they have not yet realized and may lose if the price declines later. (It may be possible to recover some or all of the tax in future years through AMT credits.)

Non-qualified stock options

NQSOs are simply stock options that do not qualify as ISOs. Typically, the exercise price is at least the stock’s FMV on the grant date (to avoid tax complications that won’t be discussed here). Also, in most cases, the NQSO itself is not considered taxable compensation. Rather, there is no taxable event until the employee exercises the option. At that time, the spread between the stock’s FMV and the exercise price is treated as compensation. It is taxable to the employee, deductible to the employer and subject to payroll taxes.

Even though NQSOs are taxed as ordinary income upon exercise, they have several advantages over ISOs. For one thing, they are not subject to the ISO requirements listed above, so they are more flexible. For example, they can be granted to independent contractors, outside directors or other non-employees. Plus, they generate tax deductions for the employer and do not expose recipients to alternative minimum tax (AMT) risks.

Restricted stock

Another choice is to grant employees restricted stock — non-transferable stock—that is subject to forfeiture until it vests (based on performance, years of service or both). Restricted stock generally will retain at least some value even in volatile times, unlike options, which may become worthless if the stock’s price declines below the exercise price.

Generally, the FMV of restricted stock is taxable to the employee (as ordinary income) and deductible by the employer when it vests. However, the employee can reduce the tax by filing an “83(b)” election to pay tax when the stock is received, converting all future appreciation into capital gains that aren’t taxed until the stock is sold. But this strategy can be risky. An employee who makes the election and later forfeits the stock will have paid tax on income that was never received.

Review your options

If you are considering an equity-based compensation plan, it is important to review the pros, cons and tax implications of various approaches. If you are not ready to share equity with employees, there are tools available that tie compensation to stock values without transferring any shares. (See “Equity Compensation Without the Equity.”)

Sidebar: Equity compensation without the equity

Companies that are not prepared to share equity with employees can still enjoy the benefits of equity-based compensation. There are several tools available that provide similar incentives — including vesting based on performance or years of service — without transferring stock (at least initially). They include:

  • Phantom Stock
    This is a bonus (usually cash, but sometimes stock) based on the value of a stated number of shares at a specific point in time or upon a specified event.
  • Stock Appreciation Rights
    These rights are similar to phantom stock, except that the bonus is based on the increase in the shares’ value.
  • Restricted Stock Units (RSUs)
    These provide a contractual right to receive stock (or its cash value) once vesting conditions are satisfied.

Generally, these awards are treated as taxable compensation when an employee receives the bonus or, in the case of RSUs, the underlying shares.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.

© 2019

Forward Thinking