It’s the end of an era, at least for Baby Boomers. Some have already retired; many more can see the finish line of their working years. For Boomers with highly appreciated company stock in their 401(k), a major decision is whether to do an IRA rollover, leave the money in the employer plan, or use the lump sum distribution tax break for net unrealized appreciation (NUA) on employer stock.
A lump sum distribution (LSD) is a one-time payment for an entire amount, rather than payments broken into smaller installments. Lump Sum Distributions are serious business with big tax benefits at stake and a mistake can be expensive and irreversible. Here are some things to consider.
- The net unrealized appreciation tax break allows the appreciation on company stock in a 401(k) to be taxed at long-term capital gains rates instead of the usual ordinary income tax rates that would otherwise apply to distribution from company plans or IRAs. This tactic can cut your tax bill in half.
- Two tests must be met to qualify for the NUA tax break
- There must be a lump sum distribution
- There must be a triggering event
- To qualify as a lump sum distribution for the NUA tax break
- The distribution must occur in one tax year
- The participant’s account balance must be zero by the end of the year.
- The stock must be distributed in kind
- The stock must be transferred to a taxable account
- The stock must be distributed to the employee
- If the stock is rolled over to an IRA, then the NUA tax break is lost forever.
Multiple Plan Issues
All funds from all like plans at the employer must be withdrawn. This includes an employee stock ownership plan or a Roth 401(k) from the same company. Generally, all like plans include all defined contribution plans at the company, but would not include defined benefit plans.
The distribution must also occur after any of these four triggering events:
- Death
- Reaching age 59 ½ (if the plan allows these distributions)
- Separation from service (not for self-employed)
- Disability (only for self-employed)
Each triggering event is a fresh start, and it provides another opportunity to take advantage of NUA. For example: if the employee reaches age 59 ½ (a triggering event) but is still employed, and takes a partial distribution from the plan in a year after this event, the NUA option is not lost. Once the employee separates from service (another triggering event) there is a fresh start and the NUA option is available again.
If the employee retires (separates from service) and then takes a partial distribution in a year after this triggering event, the NUA option is most likely off the table for his lifetime. However, when the employee dies, death becomes a new triggering event and the employee’s beneficiary can qualify for the NUA benefit.
The Tax Benefit
When the stock is distributed as part of a qualifying lump-sum distribution, only the cost of the shares when purchased in the plan is taxed. The appreciation (the NUA) is not taxed until the stock is sold, and regardless of when the stock is sold, the NUA is taxed at favorable long-term capital gain rates (Per IRS Notice 98-24) as opposed to the ordinary income tax paid on the cost of the stock at the distribution date.
Appreciation from the distribution date through the date of sale does not automatically qualify for the long-term capital gain rate. The stock would have to be held for the required time to qualify for any further appreciation (beyond the NUA) for the long-term capital gain rates.
If the plan consists of employer securities and other assets (cash, funds, etc.) the cash and funds portion of the plan can be transferred into an IRA account, or converted to a Roth IRA. All, or part of the company stock portion can be transferred to a taxable (non-IRA) account. The company stock transferred to a brokerage account still qualifies for the tax break on the NUA, even if other shares are rolled over to an IRA, as long as the LSD is done in one calendar year, which can be any year after a triggering event.
Any partial plan distributions taken after a triggering event, but before the year of the lump sum distribution, will disqualify the lump sum distribution for NUA purposes. Partial plan distributions can be ordinary distributions, in-service distributions, 72(t) distributions, required minimum distributions, or even in-plan Roth conversions and can disqualify the lump sum distribution unless there is a fresh start from a new triggering event.
If the lump sum distribution is disqualified, the NUA tax break is lost and the entire distribution, including the NUA, is taxable at ordinary income tax rates.
For example. Anna has highly appreciated stock of her company in her 401(k), so she is a good candidate for the NUA tax break. She retired in 2018 but has left her funds in the 401(k) because her advisor told her not to do an IRA rollover so she can use the NUA benefit on a future qualifying LSD. In 2019 Anna must take an RMD from the plan and she does so. In 2020 Anna wishes to do the LSD and get the NUA tax break. She cannot because she no longer qualifies due to the RMD she withdrew (which she had to) in 2019. That RMD is a partial distribution after a triggering event (separation from service).
This would have worked if Anna took a lump-sum distribution in 2019, emptying the entire balance in one year. The NUA break is now lost for Anna since separation from service was likely her last triggering event. However, if she holds the stock in her 401(k) until death, that would create a new triggering event and her beneficiaries can take advantage of the NUA break if they empty the account in one year.
Exceptions to the LSD Rule
Not all remaining plan distributions occurring in a year after the lump sum distribution will disqualify the lump sum distribution requirement. An additional contribution attributable to the last year of service will not disqualify the lump sum distribution. In addition, dividends deposited after the year-end will not disqualify the lump sum distribution.
NUA stock is stock of the employer held in the company retirement plan—the 401(k). Stock of other companies does not qualify. For example, if the employee works for Uber, then the NUA tax break only applies to the appreciation of the Uber stock in the plan.
One common question is whether the NUA tax break is available for distributions from employee stock ownership plans. Generally, yes, but not all ESOPs qualify, and the ones that do must comply with distinct ESOP-related rules. ESOPs are rich in company stock since that is required under IRC Section 4975(e)(7), so employees with these plans should not do an IRA rollover or other LSD without first evaluating the potential NUA tax benefit.
However, whether an ESOP participant can actually take advantage of this tax treatment will depend upon the terms of the plan. For example, if the ESOP does not distribute shares in-kind, but instead requires the securities to be cashed out within the plan, NUA would not be available.
Disclaimer
This information is presented for informational purposes only and does not constitute an offer to sell, or the solicitation of an offer to buy any investment products. None of the information herein constitutes an investment recommendation, investment advice, or an investment outlook. The opinions and conclusions contained in this report are those of the individual expressing those opinions. This information is non-tailored, non-specific information presented without regard for individual investment preferences or risk parameters. Some investments are not suitable for all investors, all investments entail risk and there can be no assurance that any investment strategy will be successful. This information is based on sources believed to be reliable and Alhambra is not responsible for errors, inaccuracies, or omissions of information. For more information contact Alhambra Investment Partners at 1-888-777-0970 or email us at [email protected].
