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February 18, 2009

Capital Gains Treatment

Your Guide

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Definition

Tax treatment that applies to the gain on employer securities purchased in a qualified plan, when the distributed securities are sold .

When the participant takes a distribution, the basis of the employer securities is treated as ordinary income  for the year the distribution occurs. The gain is usually not included in income until the securities are sold, at which time they are taxed at the capital gains rate.

Example:

Employee A has 100 Shares of Employer securities in his 401(k) account. The original price of the shares when they were credited to the account was $1,000. This $1,000 is the basis.

When Employee distributed (withdrew) the shares from his account, they were worth $1,500. The $500 is the net unrealized appreciation (NUA).

For the year that the shares were withdrawn from the 401(k) account, Employee was required to include the basis of $1,000 is his income. The $1,000 is taxed as ordinary income (at his ordinary tax rate).

The $500 NUA is not taxed until the shares are sold. When the shares are sold, the $500 is taxed at the capital gains rate. The $1,000 is not taxed as a result of the sale, because it was already taxed as a distribution from the 401(k) account.

If there were any additional earnings accrued on the shares before they were sold, the additional earnings are taxed at the long-term or short term capital gains rate, depending on how long Employee held them ( after they were distributed from the 401(k) account.

Referring Cite

IRC § 402(e)(4), 402(j); Prop. Treas. Reg. §1.402(a)-1(b)(1); Revenue Ruling 81-122, FORM 4972 Tax on Lump-Sum Distributions , Publication 575, Notice 98-24

Additional Helpful Information

  • IRA assets are not eligible for capital gains treatment, regardless of the source of the assets
  • Amounts rolled over to an IRA are not eligible for the capital gains treatment. Instead, those amount are treated as ordinary income when distributed from the IRA.
  • The Taxpayer Relief Act of 1997 Act provided lower capital gains rates for individuals. Generally, the 1997 Act reduced the maximum rate on the adjusted net capital gain of an individual from 28 percent to 20 percent and provided a 10-percent rate for the adjusted net capital gain otherwise taxed at a 15-percent rate. Under the The Internal Revenue Service Restructuring and Reform Act of 1998 (RRA98), property held more than one year (rather than more than 18 months) will be eligible for the lower capital gain rates provided by the 1997 Act. The provision applies to amounts properly taken into account on or after January 1, 1998.
  • The election for capital gains treatment is made on IRS Form 4972
  • In the case of a distribution other than a lump sum distribution, the amount actually distributed to a participant/beneficiary from a qualified plan does not include any net unrealized appreciation (NUA) in employer securities attributable to amounts contributed by the employee [Code Section 402(e)(4)(A) ]

Written By

Denise Appleby

Denise is CEO of Appleby Retirement Consulting Inc., a firm that provides IRA resources for financial/ tax/legal professionals. She has over 20 years of experience in the retirement plans field, which includes training and technical consultation.

Denise writes and publishes educational /marketing tools for advisors; available at http://irapublications.com. Denise co-authored several books on IRAs

Denise is a graduate of The John Marshall Law School, where she obtained a Masters of Jurisprudence in Employee Benefits, and has earned 5 professional retirement designations.
She has appeared on numerous media programs, sharing her insights on retirement tax laws.

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