Client Only Vault

Account Access

Click here to log-in to your Charles Schwab account to retrieve statements and tax documents from the website.


Rule 72(t)

More and more individuals are deciding to retire early. In the past, early retirement meant age 55. Nowadays, due in part to the slowing economy and layoffs, many individuals are retiring as early as age 50. Unfortunately, some of these young retirees force themselves to reduce their standard of living because they believe that they cannot access their retirement money, without a 10% penalty, prior to age 59 ½. With proper planning, and adherence to various IRS regulations, it is permissible to access your IRA money prior to age 59 ½ without the traditional 10% early withdrawal penalty.

Rule 72(t) comes from Section 72(t) of the Internal Revenue Code. This section of the IRS code details the conditions under which a participant who is under the age of 59 ½ can make withdrawals from an Individual Retirement Account (IRA) without the usual 10% early withdrawal penalty. For young retirees, application of Rule 72(t) presents some unique planning opportunities.

According to Section 72(t) of the Internal Revenue Code, premature withdrawals (those taken before age 59 ½) can be exempt from penalty if they are:

  • Part of a series of substantially equal payments made on a regular basis no less than annually.
  • Calculated according to one of three IRS-approved methods.
  • Continued for at least five years (60 months) or until the account owner reaches age 59 ½ - whichever is longer.

IRC Section 402 NUA Distributions

When most individuals retire, their first instinct is to rollover 100% of their 401(k) plan into an IRA. While this strategy may be appropriate for most people, if your 401(k) plan is loaded with shares of your employer's stock - you may be better off taking a taxable distribution of your company stock versus rolling it over to an IRA.

If you take a taxable distribution of your company stock you will be required to pay some income taxes now, BUT…. Internal Revenue Code Section 402 allows you to pay current income taxes only on the value of your shares when you acquired them within the 401(k) plan, and defer taxes on any Net Unrealized Appreciation (NUA). As a result, all appreciation on your company stock from the time it was purchased is not taxed until you sell your shares. When the shares are eventually sold your gain is taxed at long-term capital gains rate. This means you will pay a maximum federal capital gains rate of 15%, whereas any withdrawals from an IRA are taxed at your top federal ordinary income tax rate of up to 35%.

In addition to the income tax benefits while you are alive, there are additional tax benefits for your heirs if you still own some of the stock at your death. All appreciation on the stock from the time you remove it from your 401(k) until the time of your death will pass on tax-free to your heirs. This is known as "stepped-up basis". Assuming the shares of your company stock continue to increase once removed from your 401(k), the stepped-up basis can represent a substantial tax savings for your heirs. Please keep in mind that your heirs will still have to pay tax on the Net Unrealized Appreciation that was deferred when you removed the shares from the 401(k) plan - but not on the growth that occurs after the shares are removed from your 401(k).

This strategy makes the most sense when shares of your company stock have increased at least four-fold from the time the stock was purchased. Historically, this strategy has not been appropriate for most Corning Incorporated retirees because the share price of Corning stock was stuck in a narrow trading range for most of the 1990s, and has recently declined dramatically from its height in September 2000. For other companys however, this strategy can be very effective.

Here's how it works…

Lets suppose you have $1 million in your company retirement plan, $500,000 of which is invested in shares of your company stock. Your cost basis in these shares might only be $100,000. If you were to take a taxable distribution of these shares you would pay approximately $30,000 of federal income taxes (assuming an average blended federal income taxe rate of 30%). In addition, depending on your state of residency, you may also owe state income taxes.

In this hypothetical example, a New York State resident would pay approximately $36,500 in total income taxes to implement this strategy. While this is certainly a big check to write, especially considering that there would be no current income taxes involved in an IRA rollover, lets look at what this check buys our hypothetical customer. The difference between the current market value of your company shares ($500,000) and the basis on which your tax was calculated ($100,000) is $400,000. This $400,000 is the Net Unrealized Appreciation that is now deferred until those shares are sold. When these shares are ultimately sold, all of the Net Unrealized Appreciation (and all future appreciation, assuming a 12 month holding period) are taxed a long-term capital gains rate of only 15% versus an ordinary income tax rate that could be as high as 35%.

Because these shares are now held outside of a 401(k) plan or an IRA, you also have the ability to borrow against the value of these shares to finance retirement purchases. Loans are not permitted within IRAs. In addition, loans are not available to retirees within company sponsored retirement plans. Loans from company sponsored retirement plans are only available to active employees.

Clearly, the decision to take a taxable distribution of stock from your company sponsored retirement plan is not any easy decision to make. This difficult decision is compounded further by the fact that many financial planners, brokers, and accountants are not familiar with this strategy.

Equity Hedging

The long running bull market, intergenerational transfers of stock, and the increased use of stock options and restricted stock for employee compensation have produced an abundant number of investors who have large concentrated equity positions in their portfolios.

Many of our clients have accumulated a sizable amount of Corning stock within their 401(k) Investment Plan and/or WESPP. These clients are excited about the future growth prospects of Corning Incorporated, but at the same time they are very concerned about having such a large portion of their net worth allocated to a single security. If you have more than $1.5 million allocated to Corning stock, you may be a candidate for some equity hedging strategies utilizing derivative instruments such as Equity Collars and Prepaid Variable Forwards.

Many high-net-worth investors with concentrated equity positions seek alternatives to the outright sale of their stock. These investors may desire to retain voting rights in the company, or they may simply be prohibited from selling their stock due to SEC restricted stock rules.

An Equity Collar is a hedging strategy that is comprised of two options - a short call and a long put utilized for a specific time period (such as 1 or 2 years). When implemented against a long stock position, a collar provides the investor with a minimum and maximum value for his or her concentrated equity position. The most widely used equity collar is known as a "zero-cost-collar". In a zero-cost-collar, the investor sells a call option against their stock, and with the premium received from the sale of the call option, the investor purchases a put option. The net cost to the investor is $0.

For example, a common equity collar strategy might provide the investor an upside "ceiling" of 120% of the current stock price, while limiting the investor's downside "floor" to 90% of the current stock price. If an investor owned $2 million of Corning stock and employed this hypothetical equity collar, the investor would participate in all of the upside growth of Corning up to a ceiling of $2.4 million, and would only participate in downside price movements of Corning to a floor of $1.8 million.

Whenever an equity collar is utilized, we must be mindful of potential tax problems. If an equity collar eliminates virtually all of the downside risk and/or upside potential of holding the stock position, the IRS constructive sales rules may be triggered. If a constructive sale is determined to have occurred, any built-in gain on the stock is recognized for tax purposes as if the stock was actually sold. In addition, equity collars trigger the tax straddle rules which may limit the investor's ability to take losses, and limit the investor's income tax deduction for any investment interest paid. The tax straddle rules also may prevent holding period accrual for the stock in situations where the stock has not already been held for a year (as in the case of newly exercised employee stock option shares).

A Prepaid Variable Forward contract is very similar to the equity collar strategy. The prepaid variable forward allows the investor to protect their concentrated equity position while still participating in potential future price appreciation of the security. The primary difference between the prepaid variable forward and the equity collar is that the financial institution that is entering into the prepaid variable forward contract with the investor will typically lend the investor an amount up to the downside "floor" of the prepaid variable forward contract. If the floor of the contract is 90% of the current market value of the stock, an investor with $2 million of Corning stock could immediately receive $1.8 million in cash at the time the prepaid variable forward contract was written. This cash could then be used to invest in a diversified portfolio to further hedge the concentrated equity position, or for other cash needs of the investor.

Because these shares are now held outside of a 401(k) plan or an IRA, you also have the ability to borrow against the value of these shares to finance retirement purchases. Loans are not permitted within IRAs. In addition, loans are not available to retirees within company sponsored retirement plans. Loans from company sponsored retirement plans are only available to active employees.


Contact Us

Set-up a free, no obligation consultation to learn more about how we can help prepare a financial plan for your future.