Publication: Investor's Notebook
NET UNREALIZED APPRECIATION AND OTHER TAX PITFALLS | |
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Investor's Insight - Wednesday, February 1, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
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NET UNREALIZED APPRECIATION AND OTHER TAX PITFALLS
by Scott Burns
David Foltz was polite about it, but the message remained.
There was an error in my column on net unrealized appreci-
ation for company stock in 401(k) plans. While I had said
that such stock received a step-up in cost basis at death,
escaping taxation of gains altogether, it was more compli-
cated than that.
Death would not allow us to cheat the taxman.
If anyone knows the nitty-gritty in such matters it is
David Foltz. He's executive vice president at Texas Capi-
tal Bank in Dallas, in charge of the Wealth Management
and Trust Group. He's been one of the reigning experts on
IRAs for more than 20 years.
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So if you're one of the fortunate souls who had a long
career with ExxonMobil (a group that sometimes seems to
account for most of the residents of Houston) or someone
with a low employee number at Dell or XTO Energy, listen
up. As Foltz explains it, those who exercise the net un-
realized appreciation option with company stock and take
the stock out of the plan at retirement or separation
will face two distinct tax events at death.
First, the gain over the cost basis that occurs while the
stock is in the plan will remain subject to capital gains
taxes. Then, the gain that occurs from when the stock
comes out of the plan until death will escape taxation
through the step-up in cost basis allowed estates.
Suppose, for instance, that you have company stock in your
401(k) plan with a cost basis of $10 a share that is sell-
ing for $50 a share when you take the stock out of the
plan. Suppose also that you continue to hold the shares
and they rise to $250 at your death. What happens?
The gain between $10 and $50 will be liable for capital
gains taxes when sold. This means an heir could defer taxes
until they sell the stock. The gain between $50 and $250
will receive a step-up in cost basis and escape taxation.
I hate to sound like one who prefers blunt instruments, but
subtleties like this are one of the reasons I believe the
residents of Congress should experience cruel and unusual
punishments both before and after death. It's also why I
advocate the www.fairtax.org proposal for a national sales
tax.
I asked Foltz if he had a list of the most common errors
people make.
"The one that comes up routinely is bad information on
things like required minimum distribution (RMD) factors.
Last year, for instance, a broker at a major brokerage
firm and a CPA both cited RMD factors for 2001. In fact,
the factors had changed and they could have distributed
less. So they could have paid more taxes than they had to.
"Had they distributed less than required, there would have
been a 50 percent penalty from the IRS for underdistribu-
tion.
"Another error is not having a beneficiary designation or
naming your estate as beneficiary (of a qualified plan).
People get tired of the paperwork, and the estate has the
shortest payout."
He pointed out that careful naming of beneficiaries can
extend the tax-deferral of account assets significantly.
An IRA that goes into an estate, for instance, would have
to distribute about 6 percent a year if the decedent was
72. A group of adult children named as beneficiaries in the
IRA, on the other hand, could limit distributions to half
that amount.
"We recommend that the (surviving) spouse declare the IRA
their own because the Unified Table (for required minimum
distributions) can still be used. We always have a rollover
for the surviving spouse.
"What people don't think about is that these accounts are
going to be around for 70 years or more -- your spouse, your
children and maybe your grandchildren."
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Another pitfall?
"Not having a power of attorney acceptable to your IRA cust-
odian. That is a common occurrence. The issue is that every-
one thinks in the present tense and forgets about getting
old."
Those, unfortunately, are just the immediate and common mis-
takes. "IRAs," Foltz concludes, "are becoming increasingly
important as part of people's estates. It's important that
your attorney have all the details on these plans, if your
attorney is to provide good estate planning advice."
ON THE WEB
Journal of Financial Planning,
"Revisiting Net Unrealized Appreciation":
www.fpanet.org/journal/articles/2004_Issues/jfp0204-art7.cfm
(Investor's Insight reflects the opinions of experts. It does
not recommend any specific investments, and no endorsement is
implied or should be inferred. For more information, contact
the individual firms cited).
COPYRIGHT 2005 UNIVERSAL PRESS SYNDICATE
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