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must qualify as a lump-sum distribution (LSD), which means, under the tax code, that the entire plan balance must be withdrawn in one taxable year after a triggering event.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clients to hold the stock more than a year to qualify for long-term capital gains rates doesn't apply to NUA stock withdrawn as part of an LSD.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 The other $200,000 in mutual funds must also be withdrawn by the end of 2006, but those funds can be rolled over tax free to an IRA where they remain tax deferred.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.

  For example, if Joan retired in 2005 and took a required distribution in 2006 at age 7012, and then took an LSD from the plan in 2007, she could no longer qualify for the NUA election. Withdrawing the remaining plan balance in 2007 does not qualify as an LSD since Joan took a required distribution in 2006.

  The LSD must follow a triggering event and be a distribution of the entire balance in one taxable year. The 2007 distribution did follow the 2005 retirement, but the 2006 RMD distribution killed the NUA break.
  

• Selling out too quickly. After all the Enron publicity, many employees got scared and sold their employer stock without checking to see if it had appreciated. Once they sold the shares in the plan, they killed the NUA break on the appreciation to date. To qualify for the NUA break, the stock must be distributed as stock (in kind) in the LSD in one year. If the stock is sold while it's still in the plan, the tax break on that stock is lost.

  Every case is different. But if clients truly fear the stock will tank, you wouldn't want them to hold on to it just for the NUA. If the stock does take a dive, then there won't be an NUA break anyway.
  

• Forgetting to tell beneficiaries about NUA. NUA is not just for plan participants; beneficiaries get it, too. Most people don't know this. If your client is in a qualified plan and dies with funds in the plan, the beneficiary can claim the NUA tax break on an LSD.

  This is more common than you may think. If your client dies with funds still in the plan, and the beneficiary is a child or grandchild (or any non-spouse beneficiary), the plan probably won't allow a lifetime payout over the beneficiary's life expectancy (like the stretchout from an inherited IRA). The plan is likely to force an LSD, and the beneficiary will owe all the tax at once, ending the tax deferral. That's because a non-spouse beneficiary can't do a rollover, so once the funds are distributed, they are all taxable.

  If the plan forces an LSD and there is appreciated employer stock in the plan, the beneficiary qualifies for NUA treatment. This may save the beneficiary a ton on taxes, plus the tax on the NUA can be deferred until the stock is sold. But a beneficiary who inherits unsold employer stock with NUA doesn't get a step-up in basis on the NUA portion of the stock.

If you can help your clients avoid these five pitfalls, they--and their beneficiaries--may be in a position to reap a big tax break. Once again, demonstrating a thorough understanding of retirement planning will help you to build your business and ensure client loyalty.

Ed Slott, a CPA in Rockville Centre, N.Y., is a nationally recognized IRA distribution expert, professional speaker and author. He has also created The IRA Leadership Program and Ed Slott's Elite IRA Advisor Group. You can visit his website at www.irahelp.com.

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