The Rollover That Would Have Cost Her Twice
Eun-ji, 58, retired from her employer in March and holds a 401(k) of 480,000. Of that, 120,000 is employer stock with a cost basis of 30,000, and she has 30,000 of after-tax contributions in the plan. She wants to pay off a 70,000 mortgage this year, consolidate the rest into an IRA, and simplify to one statement. Her plan permits distributions after separation from service and will distribute employer securities in kind on request. She also has an inherited IRA from her mother, who died in 2018, from which she has taken an annual withdrawal each year, and she is considering folding that account into the new IRA to reach the single statement she wants. Her marginal ordinary rate is 32%, long-term capital gains rate 15%, and she expects to be in a similar bracket for several years.
1. She wants the 70,000 taken from the new IRA after the rollover. Is that the right sequence, and why?
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It is the wrong sequence and it costs her money. She separated from service in the year she turned 58, which is after 55, so a distribution taken directly from the employer plan is exempt from the early-distribution penalty; it is still ordinary income, but it avoids the extra 10%. If she rolls the full 480,000 into an IRA first and then withdraws 70,000 at age 58, the separation-from-service exception does not follow the money into the IRA. The IRA answer is the 59½ rule, which she has not reached, so the 70,000 would face income tax plus the penalty.
The correct order is: take the 70,000 distribution from the plan first, then roll the remainder directly. Confirm the plan allows the partial distribution, quote the withholding so she is not surprised by a reduced check, and remember that withholding is a prepayment, not an additional tax. Also isolate the after-tax basis: 30,000 of basis should be tracked so it is not taxed twice, and the plan may be able to distribute basis separately. Put the sequence and the arithmetic in the file before submitting any paperwork, because reversing it after the rollover is not possible.
2. Compare rolling the 120,000 of employer stock into the IRA with taking it in kind.
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Rolling the stock into the IRA defers all tax but permanently forfeits net unrealized appreciation treatment. Every dollar eventually comes out as ordinary income at her 32% rate.
Taking the shares in kind into a taxable brokerage account works like this: the 30,000 cost basis is ordinary income in the year of distribution, the 90,000 of net unrealized appreciation is taxed as long-term capital gain whenever she sells, regardless of how long she holds the shares after distribution, and appreciation after distribution gets ordinary short- or long-term treatment based on holding period. At a 32% versus 15% spread, the 90,000 of NUA saves roughly 15,300 in tax compared with rolling it, and it removes 120,000 from her future required minimum distributions.
The trade-offs: she pays tax now on the 30,000 basis, she carries a concentrated single-stock position in a taxable account, and the benefit shrinks sharply if she would otherwise hold the stock for decades inside the IRA. Run the numbers both ways, show her the comparison, and document the election. Confirm in writing that the plan will deliver the actual shares rather than cash.
3. What must be handled with the inherited IRA, and what sequencing should the whole year follow?
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The inherited IRA cannot be merged into her own IRA. Her mother died in 2018, before the five-year and ten-year rules changed for most beneficiaries, so as a designated beneficiary she may generally continue distributions over her own single life expectancy and must take an annual required minimum distribution. Merging it into her own IRA would be an impermissible recharacterization of the account's status, would lose the stretch schedule, and would corrupt the basis and beneficiary records. It also risks a missed-RMD penalty that is far larger than the statement consolidation she is trying to achieve.
Sequence the year as follows: (1) confirm the inherited IRA distribution for the current year has been taken and keep that account titled separately with its own beneficiary designation; (2) take the 70,000 from the plan, with withholding elected; (3) distribute the 120,000 of employer stock in kind to the taxable account and record the basis and NUA; (4) roll the remaining balance, including the after-tax basis as tracked, by direct trustee-to-trustee transfer. Doing the taxable events before year-end lets her control which tax year absorbs the income. Avoid any indirect rollover, because the 20% withholding and the sixty-day clock would force her to find replacement cash.