ESOP options prior to age 59.5
I need guidance on a new client with the following:
- Age 55
- Has a $700k ESOP in company that he separated from over 10 years ago.
- He wants diversification
Since he has separated from the company over 10 years ago and is age 55, would he be eligible to have the ESOP transferred to a traditional brokerage account, pay income tax on the cost basis, pay no early withdrawal 10% penalty, diversify the stock, and pay long-term capital gain tax via the NUA tax break provision on the appreciated value. Otherwise, is the next best thing for diversification that we would roll it over to an IRA and diversify it. My understanding is that the NUA tax break along with being exempt from the early withdrawal penalty must be done after age 59.5 and from the company’s stock (not diversified within the ESOP).
Permalink Submitted by Alan - IRA critic on Tue, 2024-05-14 20:03
Client should request a cost basis quote from the ESOP, and also confirm that the entire plan balance is eligible for a lump sum distribution (LSD). Some ESOPs limit annual distributions. In addition, if client also has a 401k balance, that plan must also be distributed in the same year for the ESOP distribution to be a qualified LSD.
If the cost basis is low enough to justify NUA treatment, the LSD can be requested. Client will owe ordinary income tax on the cost basis and also the 10% penalty, because separation occurred prior to age 55. Upon sale of shares, the NUA will be taxable at the lower LTCG rate. However, since diversification is a prime goal client would likely sell shares in the first year and any gains generated after distribution but prior to the first year sales would be taxable at ordinary income rates. After the first year, all gains would be long term.
If the shares paid dividends that were reinvested in more shares, those reinvested dividends over the last 10 years would have diluted the original cost basis. Client should be sure NOT to have dividends reinvested in the taxable account either, as that would be contrary to diversification and would further complicate reporting the sales on Form 8949.
Permalink Submitted by Eric Stats on Mon, 2024-05-20 16:55
Alan, is the 10% penalty on only the cost basis or on the entire amount?
Permalink Submitted by Alan - IRA critic on Mon, 2024-05-20 23:28
It’s only on the taxable cost basis (the amount in Box 2a of the 1099R). It’s also possible to qualify for a penalty exception other than separation at 55 or being 59.5 such as disability or very high unreimbursed medical expenses.