After-tax Qualified Plan to Roth-maybe a different strategy?
I know this is being discussed endlessly on here and elsewhere because our friendly neighborhood revenue agents and congresspeople refuse to just make things easy!!
Anyway, here is my situation and a thought I just had:
– Client has a 401(k) with about $615,000 total in it. She retired last year and has not taken any distributions.
– Of the $615,000, about $108,000 is employer stock (cost basis = ~$48,000) – originally I was hoping to move this to a Roth but IRS seems pretty clear now that this will not be allowed (at least without paying tax on the entire amount at ordinary rates)
– A small piece of that stock (about $12,000) actually came from after-tax contributions
– Of the total $615,000, about $144,000 is from after-tax contributions (including the 12,000 in the stock)
From what I can gather from reading on here and my own research, it is unclear whether the service will look favorably upon what would be my first choice for distribution:
Lump-sum distribution in 3 pieces: A) In-kind distribution of employer stock with plan to take advantage of NUA rules, B) direct rollover of after-tax amount to Roth IRA and C) direct rollover of all pre-tax amounts plus, if possible, earnings attributable to after-tax amounts to a TIRA.
I gather that there is a fair amount of consensus that the above could essentially be accomplished via an indirect rollover with no tax liability in the year of distribution aside from ordinary income on the basis of the stock as long as 20% withholding can be replaced from other funds.
I believe qualified plan administrators are not required to withhold the mandatory 20% on the value of employer securities distributed in kind from the plan. Can anyone confirm this? If this is true, could we theoretically, purchase more employer stock inside the plan prior to distribution (possibly even the whole balance or close to it for one day). Once this is done, we request a lump-sum distribution in-kind of the entire plan interest which would consist of employer stock and, thus, not be subject to the 20% withholding.
Once this is complete, could we either then roll pre-tax amounts first to the TIRA and after-tax to the Roth and continue to hold some of the employer stock outside as we would have done before? I know this throws in some additional complications and I’m hoping you can help me sort through some of the issues. As I see it, if we want to take advantage of NUA rules at all, we must be sure we don’t do anything to create a failure on qualification as a lump-sum distribution as defined in the code. So, if this idea would work as a way to avoid withholding, the question is can we then split out the stock based on the original dollar source of the funds used to purchase it in the plan?
Alternatively, if that option would not work – any thoughts on doing the same thing but not utilizing NUA and only splitting TIRA and Roth?
Thanks for any input. I hope my explanation is clear enough for everyone to understand what I am asking.
Thanks,
Dan
Permalink Submitted by Alan Spross on Thu, 2010-02-18 19:18
With respect to mandatory 20% withholding on NUA shares, according to the 1099R Inst, the exemption is a two step process:
1) The cost basls portion of the NUA shares DOES COUNT toward the amount the 20% is applied to
2) BUT – the actual withheld amount withheld cannot be more than the amount of cash and property OTHER THAN the employer shares distributed. Cash for fractional shares is also exempted up to $200.
So essentially, in most cases there is no withholding, but if you want to actually use NUA, you have to do this distribution first unless the plan accounting for cost basis is done by lots instead of average cost. If the plan uses average cost for all employer shares, if you bought a bunch of these shares after doing the first distribution to actually use NUA, the average cost basis could be substantially increased by the purchase of all those other shares and that would destroy the NUA benefit as evidenced by the numbers that would appear on your 1099R. On the other hand, if the plan does NOT use average cost accounting, you might be able to distribute the original low cost NUA shares or even the lowest cost lots available for actual NUA use. Then, if you bought more shares later on that you did not intend to use for NUA, the high cost basis of those later purchases would not matter.
Moving on to the second step, exchanging all the remaining plan assets for company stock is again subject to plan approval. Recent implosions in some shares may well have resulted in limits in how much company stock you can own in the plan. This protects the company somewhat from those stock drop lawsuits. But for a moment, assuming you can purchase unlimited numbers of company shares and had them distributed, the company would have to issue a separate 1099R for them to avoid messing up the real NUA distribution done earlier. You then have the two indirect rollovers to complete, either in kind or using the cash proceeds from the sale of those shares. FIrst the pre tax amount including all earnings to the TIRA and then the after tax amount to the Roth IRA. Note that the plan might allocate some of your actual after tax contributions to company stock, and that would decrease the cost basis amount subject to ordinary tax but would decrease the after tax amount left over to convert to a Roth IRA from the other assets.
In summary, what you propose appears workable, but is heavily dependent on knowing up front the accounting regimen that your plan applies to NUA shares. Most plans use average cost, and if so the purchase of all those new shares could ruin your use of NUA on the shares you want. Another possibility to check out is whether the new shares you purchase as an investment choice are considered NUA shares by the company or not. It is possible that only shares purchased by payroll deduction or company match and forfeitures are NUA shares. That would eliminate the new shares from the 20% withholding exemption. The IRS is going to expect that your return matches up with the 1099R issued, so the challenge is not so much with the IRS as with understanding what the plan provisions are, and assurance that the 1099R (one or more) will reflect what they tell you.
Permalink Submitted by Daniel Baratz on Fri, 2010-02-19 14:58
Alan,
Thank you for the detailed response. I am confused about a couple of things you said. Please clarify if you know the answer:
1. I thought that in order to take advantage of the special NUA rule, it must come as a lump sum distribution from the plan. My understanding of this would mitigate the possibility you discuss of doing the distribution in multiple pieces.
2. I didn’t think the company and/or the plan document had any control over NUA treatment of a distribution. Isn’t any employer-issued security (including bonds) eligible for that treatment unless the taxpayer elects otherwise?
Thanks,
Dan
Permalink Submitted by Alan Spross on Fri, 2010-02-19 18:24
Dan,
1) A qualifying LSD is defined differently for NUA purposes than for other purposes. However, in all cases the LSD requires distribution of the entire plan balance within a single tax year. It can be spread over several distributions within that year, but it is critical that the entire balance (of all plans or a similar kind) be out by year end. Therefore, the process should be started in plenty of time to avoid any December deadline issues. For NUA, the LSD must also follow a “triggering event” such as separation from service or reaching age 59.5. (Ref Pub 575, p 15).
2) With respect to NUA and the basic LSD you are correct. However, plans are allowed some accounting flexibility in assigning cost basis and after tax contributions to the shares. Most plans use average cost over all the shares, but those that account separately for different lots based on one reason or anther present some planning opportunities to the employee. The most obvious of those is to select the lowest cost shares for NUA, but roll the others to an IRA and perhaps sell them tax deferred in the IRA to maintain diversification. Assignment of after tax contributions to NUA shares will reduce the taxable cost basis for the year of the LSD.
Remember that the average cost basis of the shares for NUA must be figured first by the plan and has absolutely nothing to do with the amount of total basis in the plan from after tax contributions. But the latter can then reduce the taxable amount of that cost basis for the LSD year without changing the Sch D cost basis when the NUA shares are eventually sold.
Therefore, your plan could work, but tops out in the complexity area since you are combining multiple strategies where timing and the correct order of things is critical.