An in-kind distribution is an often overlooked yet simple process that could save taxes while maintaining investment allocation. They allow you to withdraw specific investments rather than cash. Whether you want to satisfy the required minimum distributions from a retirement or inherited IRA account, implement the net unrealized appreciation strategy, or continue to hold a specific investment, you can implement in-kind distributions to your advantage.
In-Kind Distributions
No requirement says you must only withdraw cash from your 401k, IRA, Roth IRA, or inherited IRA. You can transfer stocks, bonds, funds, or other securities directly into a taxable investment account via in-kind distributions. Roth in-kind distributions are still tax-free, assuming you’ve met all other Roth requirements. On the other hand, in-kind distributions from your pre-tax retirement accounts are still taxable.
Reasons to consider in-kind distributions
There are a few reasons to consider an in-kind distribution
- Net Unrealized Appreciation (NUA) Tax savings
- To satisfy Required Minimum Distributions (RMDs)
- You want to continue to hold a specific investment
Net Unrealized Appreciation
When you have shares of your employer’s stock in a qualified retirement plan, distributing those shares in-kind allows you to take advantage of any NUA, which is the gain accumulated on your company’s stock in your retirement account.
Typically, distributions from tax-deferred retirement accounts are considered ordinary income. However, when using NUA to withdraw your employer’s stock in-kind into a taxable investment account, income tax only applies to the amount you paid for the stock, its cost basis, not its current fair market value. The benefit is that the lower capital gains rate is applied to the gains when sold.
Here’s an example
Suppose Mary purchased $100,000 of her employer’s stock over the years. It is now worth $250,000. She uses the NUA strategy and moves the stock from her 401(k) to a brokerage account. She will be subject to income tax on the $100,000 cost basis. The gain of $150,000 would be taxed later when she decides to sell the stock. She would be subject to capital gains rates on the $150,000 gain and any additional appreciation since moving to the brokerage account.
The distribution would be taxed at the lower 0%, 15%, or 20% capital gains rates, depending on her income.
There is also an advantage to Mary’s estate planning. If she died before selling the stock, her heirs would receive a step-up in basis on the value of the stock at Mary’s death. Once the heirs decide to sell the stock, they would only be subject to capital gains tax on the gain between the value at Mary’s death and the sale. That could be significant tax savings for his heirs.
If she rolls the balance of her 401(k) into an IRA, her assets will continue to grow tax-deferred, but the higher income tax rates apply to all distributions. Secondly, IRA assets do not offer a step-up in basis for beneficiaries. All IRA assets would be taxed at the beneficiary’s income tax rate at Mary’s passing.
To learn more about NUA, read our blog post, “Using Net Unrealized Appreciation to Reduce Your Taxes in Retirement.“
Retirement RMDs
If you’re 73 or older, you must take your annual RMD from your pre-tax qualified retirement accounts, such as IRAs and 401ks.
The in-kind distribution strategy is less beneficial if you need your RMD to cover living expenses. However, RMDs are often more than what you need. That’s when in-kind distributions can be helpful.
Instead of selling investments in a retirement account and distributing the cash, you can do an in-kind RMD by transferring specific investments from your IRA to a taxable account. The RMD is the investment’s fair market value at the time of the transfer. You will owe income tax based on that fair market value of the distribution. You’ll need to come up with some cash to pay the taxes you owe on the withdrawal from inside or outside the retirement account.
Inherited IRA RMDs
Please note that in-kind distributions also work for inherited accounts. If you are required to take distributions from inherited or Roth IRAs, you can do so via in-kind distributions. The Inherited IRA distributions are still subject to income taxes, and the Roth distributions remain tax-free.
The in-kind distribution benefits
Once an investment is transferred from an IRA to a brokerage account, except the NUA strategy, its cost basis resets to the fair market value on the date of the transfer. If you hold the stock for more than a year before selling, the gain is taxed at the lower long-term capital gains rates.
By contrast, if you liquidate securities from your IRA to meet your RMDs and then use those funds to rebuy that same investment in your taxable account, the security price could change in the interim. There is always the danger that the asset price could increase, resulting in repurchasing at a higher price. Yes, the chance of a wild swing is low. Moving cash from a retirement account to an investment account could take you out of the market for two to seven days, depending on how the funds are transferred. While with an in-kind distribution, it’s not an issue.
Poor Investment years
Not every year is a banner year when it comes to investing. Some years are downright terrible. You may even have a high RMD even though the value of your retirement portfolio has declined during those occasional not-so-good investment years. You can make the most of the situation by taking the securities in kind when the security value is depressed, so you don’t have to sell low and can wait for the market recovery.
You have an investment soft spot
It may be an investment you inherited from a parent or that favorite company you own, or it may be that it’s just not a good time to sell a specific investment; in-kind distributions give you some flexibility if selling is not something you really want to do.
Again, your tax bill will remain the same since a distribution is a distribution, whether cash into your bank or an in-kind distribution of investments. However, transferring securities in-kind from your IRA to a taxable brokerage account may make sense. It can help you maintain the same market exposure in a different account or keep that favorite investment.
The In-Kind Distribution Bottom Line
In-kind distributions offer a valuable yet frequently underutilized strategy. Whether managing RMDs, implementing the NUA strategy, or simply aiming to retain certain investments, in-kind distributions can be a powerful tool in your financial arsenal. As we’ve explored, leveraging this approach can provide substantial benefits, making it a strategy worth considering for those looking to optimize their investment and tax management strategies.
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