NUA or ROTH Conversion?
I have a client who has an old 401K valued at $400K. He is now at a new company. Of the $400K, he wants to transfer $110K in company stock to a personal brokerage account under the NUA rules. However, his accountant told him that because he is only 55 years old he would not only pay the regular income taxes on the transfer (most of it is low or no cost basis as it was awarded as part of his 401K matching funds) but would also have to pay a 10% penalty because he is under 59 1/2.
The accountant suggested that he transfer the company stock to an IRA rollover specifically for this stock only and THEN transfer the value in that segregated IRA rollover into a ROTH IRA. The client has sufficient outside cash to pay any taxes on a ROTH conversion.
What are your thoughts about this plan? Would there be a 10% penalty and is the transfer to a rollover IRA then to a ROTH a better way to proceed?
Permalink Submitted by Alan Spross on Tue, 2010-04-13 17:43
It sounds like he separated from the prior company holding the old 401k prior to the year he turned 55. If so, the 10% penalty would apply to the cost basis portion of the LSD (not to the NUA value) if he takes the LSD prior to turning 59.5. Also, note that the cost basis of the NUA shares is determined by what the plan paid for the shares for both his own and company matching shares. He should get a cost basis quote for the company shares. Since he is no longer there, the only thing that would change that cost basis from here would be reinvested dividends. But without a cost basis figure per share, it would be premature to forego NUA permanently by doing an IRA rollover of those company shares or even selling those shares in the plan. Unless he needs the funds right away, the cost basis should be below 30% of the present FMV to make NUA particularly appealing. In addition, the top LT cap gain will probably be increasing above 15% in the near future.
I wonder if the accountant thinks that a Roth conversion of these shares will be taxed based on the NUA cost basis. If so, that is not correct. A conversion would be fully taxable except for any after tax contributions in the 401k plan if he converts directly from the 401k plan or except for non deductible IRA contributions and rollover of after tax 401k contributions if he converts via a TIRA. There is no way to take advantage of NUA and still convert those same assets to a Roth IRA.
One plan to consider if the former plan allows is would be to transfer the other 290k to a TIRA and then do a 2010 Roth conversion of an optimal portion of that if a Roth conversion would otherwise be advisable. That way he could keep his NUA options alive for future use. When he reaches 59.5, that constitutes a new triggering event for a qualified LSD which is required to utilize NUA. If he rolls over the other assets now, that rollover is an “intervening distribution” and that means that he will have to wait until 59.5 if he wants to utilize NUA. He can also wait longer, but he cannot take intervening distributions from the old 401k after 59.5 without blowing the chance to use NUA. In other words, he could do a Roth conversion now from assets other than employer stock and still preserve NUA potential for some future date. The NUA can also increase over that time frame, meaning his cost basis % of the total value would decrease.
The IRS recently ruled that a direct Roth conversion would be taxed in the same manner as if that employer plan was first rolled to a TIRA which was the ONLY TIRA that the employee had, and then converted to a Roth IRA. That in itself eliminates the possibility of using NUA in conjunction with a Roth conversion because the NUA is forfeited once the assets are rolled into an IRA of any type.
Permalink Submitted by Donna Smith on Tue, 2010-04-13 18:29
“It sounds like he separated from the prior company holding the old 401k prior to the year he turned 55. If so, the 10% penalty would apply to the cost basis portion of the LSD (not to the NUA value) if he takes the LSD prior….”
[b]What does the acronym LSD stand for?[/b]
Thank you for your quick and thorough response.
Permalink Submitted by Alan Spross on Tue, 2010-04-13 18:39
Lum sum distribution.
This is a complete distribution of all the assets in retirement plans of a certain type in the same year. To use NUA, there must be an LSD and it must also be qualified, meaning that it must follow a triggering event with no years of distributions between the triggering event and the LSD year. Triggering events are separation from service, reaching 59.5, disability for the self employed or death. This is why if he choose to distribute any of the assets now, then he must wait until 59.5 to do the LSD if he wants to use NUA.
Should also mention that diversification needs should always trump the tax benefits of NUA. Enron, Lehman Bros and many others prove that. And he has over 25% of the plan in the stock of one company, which is generally far too much unless he has much more in other assets outside the plan.