If your clients hold employer's securities in their qualified plans, they may enjoy favorable tax treatment. The tax break comes from net unrealized appreciation (NUA), but it is only available if your clients play by the rules.

The NUA tax break applies when clients have the highly appreciated stock of their employer in their qualified plan, and they elect to take a lump-sum distribution. The employer stock is distributed to them, and the other assets in the plan are generally rolled over to an IRA. The clients owe income tax only on the cost basis of the employer stock. The difference between the cost basis and the market value of the stock is the NUA, which is taxed at long-term capital gains rates when it is sold. When there's a large appreciation in company stock held in the plan, clients should consider the NUA tax break.

The distribution must qualify as a lump-sum distribution (LSD), which means, under the tax code, that the entire plan balance must be withdrawn in one taxable year after a triggering event. A triggering event is a separation from service, death, disability or reaching age 5912.

The NUA isn't taxed until the shares are sold, and clients only pay tax at long-term capital gains rates--even if they sell the shares the day after the distribution. The rule requiring clients to hold the stock more than a year to qualify for long-term capital gains rates doesn't apply to NUA stock withdrawn as part of an LSD.

Assume that Bill will retire in 2006. His company 401(k) plan balance is $1 million: $800,000 in employer stock and $200,000 in assorted mutual funds. The cost to the 401(k) plan of the $800,000 in stock is $100,000. If Bill takes a qualifying LSD (distributing the entire plan balance by the end of 2006) and transfers the $800,000 to a taxable brokerage account (a non-IRA account), he only has to pay ordinary income tax on $100,000. The other $700,000 ($800,000 in stock minus the $100,000 cost) is NUA and is not taxed on the transfer of the shares to the brokerage.

When any or all of the employer stock is sold, Bill will pay long-term capital gains rates, now only 15%, on the NUA attributable to that stock, regardless of how long (or short) the stock is held after it was distributed from the plan. The other $200,000 in mutual funds must also be withdrawn by the end of 2006, but those funds can be rolled over tax free to an IRA where they remain tax deferred. That's a great deal for Bill, unless he makes one of these five NUA mistakes.

THE FIVE PITFALLS

• Forgetting to check before making an IRA rollover. Advisers must ask clients if there is any appreciated employer stock in their plan before rolling it over into an IRA. Once you roll the employer stock to an IRA, the NUA tax break is lost forever, since this is an irrevocable election.
  The IRS made that clear in Private Letter Ruling 200442032. A taxpayer had made an IRA rollover. He asked the IRS for a ruling letting him revoke his rollover election and treat the employer stock as if it were distributed to him personally so it would qualify for NUA treatment. The IRS said the rollover was irrevocable.
  
• Not withdrawing all the funds. If a client takes an LSD, all of the company plan funds must be distributed in one taxable year. This doesn't mean that the client must pay tax on all those funds. The client can roll the non-employer stock plan funds into an IRA. He or she can even roll some of the employer stock into an IRA and only pay income tax on the cost of the shares withdrawn. But, if there is any balance left in the plan at year-end, the client will blow the NUA tax break.

  In a 2004 case, a taxpayer attempted an LSD from his company plan, but not all of the plan funds were distributed that year. The taxpayer realized this too late and withdrew the remaining funds early in the following year. The taxpayer then re-quested a PLR asking the IRS to allow the distributions to count as an LSD so he could use the NUA tax break. The IRS denied the request in PLR 200434022, adding that the taxpayer had to pay ordinary income taxes on the entire amount of employer stock withdrawn from the plan.

  Using Bill as an example again, assume he withdrew $800,000 of stock from the plan and transferred it to a taxable brokerage account. But due to an oversight, the remaining $200,000 in mutual funds was not withdrawn until early the next year. The result of this error is a tax on the entire $800,000 of stock withdrawn from the plan at ordinary income tax rates. In addition, if it was an early withdrawal, he would owe a 10% penalty of $80,000. Advisers must monitor all LSD attempts to make sure that the plan balance is zero at year-end, or risk costly consequences.
  

• Taking partial-plan distributions. Partial-plan distributions like required minimum distributions (RMDs), 72(t) distributions and in-service distributions taken after a triggering event, such as separation from service, can kill the NUA tax break. Remember that the entire plan balance must be withdrawn in one taxable year after a triggering event.
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