401(k) Lump Sum Distributions – Tax Advantages, Rollover to IRA, Tax Deferred Contributions and more

(July 24th, 2009)

A lump sum 401(k) distribution means the entire balance in your 401k account is withdrawn in a single calendar year for many reasons, some of which could be reaching age 59 and ½ years, leaving your current employer, or suffering a disability. Note that if you are less than 55 years of age, leave your current employer and take an entire cash lump sum distribution of your 401k account rather than rolling over to an IRA, you will be subject to a 10% early withdrawal penalty, which you want to avoid. The best way to handle such a situation if you have to take a lump sum distribution before the age of 59 and ½ years is to roll over to an Individual Retirement Account (IRA).

For instance, assume you have $100,000 in your 401(k) account of which $50,000 is invested in your employer stock. First you must meet the lump sum distribution requirement and distribute the entire $100,000 within a single calendar year. If you make a mistake at this point, you will end up owing taxes to the IRS as well as face stiff penalties. The next step is to differentiate your employer stock from your other 401(k) contributions by rolling over the 401(k) contributions to an Individual Retirement Account (IRA) where it can continue to grow tax deferred. On the other hand, the employer stock should be put in to a taxable account paying income tax on the basis of the stock value during original purchase.

For instance, assume you initially put only $30,000 in your employer stock, and this stock has appreciated to $50,000 in 2 years. You will pay income tax on the initial $30,000 that you invested in to your employer stock NOW. When you sell your employer stock, you will have to pay capital gains tax on the additional $20,000 appreciation. Thus, this $20,000 is calculated as follows:

The $20,000 appreciation is also known as net unrealized appreciation (NUA). It is known as this because you have not actually exercised the $20,000 appreciation, you just hold your employer stock and have not yet sold it and taken cash. When you do sell and take the cash, you will have to pay capital gains tax on this $20,000. Make sense?

Important Notes

What is a Lump Sum distribution? – A lump sum distribution is one or several payments of an entire withdrawal of your 401(k) account in a given single year. For instance, if you have $200,000 in your 401(k) account and withdraw $100,000 in March 2009 and another $100,000 in November 2009, then you meet the eligibility for a lump sum distribution. However, if you withdraw the 2nd batch of $100,000 in January 2010, then you do NOT meet the eligibility of a lump sum distribution. This is what gets most people confused.