Steer clients clear of lump-sum distribution errors

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Aging hippies who once fretted about the bad brown acid going around at Woodstock should now be on the alert for another, potentially treacherous, type of LSD — lump-sum distributions.

LSDs are serious business with big tax benefits at stake, and a mistake could be expensive and irreversible. Baby boomers retiring or leaving their companies in record numbers will need help making critical decisions, specifically: Should they do an IRA rollover, stay with the plan or use the LSD tax break for net unrealized appreciation on employer stock?

Following is a primer on the essential points. First, however, ask your client two questions: Do you have company stock in your 401(k)? And, is it highly appreciated, i.e. what was the cost when the shares were put in the plan and what is today’s value of those shares?

First, the basics. 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 distributions from company plans or IRAs. This tactic can slash the tax bill in half, so all financial advisors should know to address this with clients who may qualify.

To qualify for the NUA tax break, these two tests must be met:

  • Must be a lump-sum distribution
  • 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, and the participant’s account balance must be zero by the end of that year. The stock must be distributed in kind — as stock — to qualify, and be transferred to a taxable account. It’s important to note that if the stock is rolled over to an IRA, then the NUA tax break is lost forever. The stock must be distributed to the employee to qualify for NUA.

All funds from all like plans at the employer must be withdrawn. This would include an employee stock ownership plan or a Roth 401(k) from the same company. Generally, all like plans would include all defined contribution plans at the company and would not include defined benefit plans.

The distribution must also occur after any one of these four triggering events:

  1. Death
  2. Reaching age 59 ½ (if the plan allows these distributions)
  3. Separation from service (not for self-employed)
  4. 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 yet. 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.

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 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.

Let me give you one 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 has told her not to do an IRA rollover so that 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.

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 yearend 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 in 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.

Advisors can help clients evaluate the NUA benefit and guide them carefully through the LSD process avoiding any disqualifying transactions.

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Tax planning ESOPs 401(k) Retirement planning Client strategies RMDs Capital gains taxes IRS