Tax-deferred 401(k) distributions.

In private letter ruling 9721036, a taxpayer over age 591/2 qualified for an in-service distribution of cash and employer stock from a qualified 401(k) plan. The taxpayer sought to roll over the cash into an individual retirement account and keep the employer stock. The Internal Revenue Service ruled the rollover did not affect the status of the distribution as a qualified lump-sum distribution. Thus, the taxpayer was not currently taxed on the net unrealized appreciation of the employer stock.

Take, for example, a taxpayer who participates in the company 401(k) plan. The plan invests in several assets, including $20,000 in the employer corporation stock, which the taxpayer's company pays for. While in the 401(k) pension trust, the value of the employer's securities skyrockets to $100,000. How will the taxpayer be taxed if he or she takes the employer stock out of the plan?

Under Internal Revenue Code section 402(e)(4)(b), if the taxpayer receives the employer stock as part of a lump-sum distribution, then he or she will be taxed currently only on the stock's cost of $20,000 and the net unrealized appreciation of $80,000 can be tax deferred. In order for the distribution to be a lump-sum distribution, the taxpayer must receive the entire account balance within one year after (a) reaching age 591/2, (b) death, (c) separation from service or (d) becoming permanently disabled (if self-employed).

Observation: Assume six months later the taxpayer sells the stock for $115,000. The taxpayer must report a long-term capital gain of $80,000 (the net unrealized appreciation) and a short-term capital gain of $15,000. If the stock is held for more than a year before it is sold, the entire gain of $95,000 would be long term.

If the taxpayer had wanted to, he or she could have elected to be taxed on the entire $100,000 in the year of the lump-sum distribution.