Inheriting an ESOP-Followup #2
A client’s mother recently passed away and one of her assets is an ESOP of a non-public company. I don’t have a lot of information yet to know if NUA is an issue. Assuming the beneficiary form is correctly completed naming the one child beneficiary, can this be rolled into an Inherited IRA? If NUA is a large percentage which I doubt, I assume it may make sense to take it as a lump sum. How does NUA play with the tax impact of conversion to a Roth?
Permalink Submitted by mk foss on Fri, 2012-06-01 17:59
An ESOP with a stock that is not publicly traded does cause a few problems. Ordinarily the beneficiary has a “put” so that the plan must redeem the shares. How that redemption works with a nonspouse rollover, is a question that depends on how the plan is administered.
NUA is a benefit available if someone takes the shares directly instead of rolling them to a Roth or to a beneficiary IRA. At one time it was thought that the Roth conversion would be measured by the plan cost of NUA shares instead of the FMV but IRS has come out to say that is not the case.
There are a lot of questions that should be asked of the plan administrator to determine what the options are under that plan. The IRS regulations give a framework but the plan can be more restrictive. However, the nonspouse rollover is available even if the plan doesn’t provide for it – but how it will work with the nonpublic shares is a question. The rollover must be accomplished by a transfer – so the beneficiary needs to know if cash or nonpublic shares would be transferred.
Permalink Submitted by Alan Spross on Fri, 2012-06-01 18:19
It’s a difficult analysis that will require determination of the benefit of an inherited Roth IRA vrs an inherited TIRA. The usual considerations for converting to a Roth IRA apply here but should be made somewhat tougher since an inherited Roth will have RMDs that erode generation of tax free earnings. With either IRA type, shares could be sold to diversify without current taxes.
Once the above decision is made, the result should be compared to taking the LSD for NUA purposes. Here the need to diversify should trump tax considerations if the current ESOP balance is large enough. This comparison depends on the beneficiary’s current tax rate, the current LT cap gain tax rate and the projected changes to both come January. In most cases, NUA will only be preferable if the cost basis is less than 30% of FMV, but if the beneficiary needs the money very soon, the 30% could be increased since the shares would be sold very soon and the total tax bill would be less than transferring to any type of IRA and then taking distributions.
There is no penalty involved since the shares are inherited.
Permalink Submitted by Jeffrey Moss on Fri, 2012-06-01 18:32
Thanks to both of you for your responses. The amount involved is fairly material to the beneficiary, roughly $700K. The beneficiary does not need the money, so a rollover is in play. I just received the Plan Document and Summary Plan Description. I need to read the death provisions a few times as the language is not very clear and appears to conflict with other parts of the document. The default is a 5 year payout, but in some areas it refers to a payout upon death in the following year. Diversification is critical in my mind, as it is a private company in an industry I would not consider highly stable.
Permalink Submitted by Jeffrey Moss on Mon, 2012-06-04 15:05
After reviewing the plan documents, here is how the distribution will work:
The plan balance will be distributed over 5 years, beginning in the year following the participant’s death and based on the most recent valuation prepared prior to date of death. There is no provision for taking it out as a single lump sum. Presumably the beneficiary will be able to roll each of the 5 distributions to a TIRA or Roth. No question here, just providing the terms of the plan as an FYI.
In addition to the ESOP, the beneficiary is receiving an IRA which will be converted to an Inherited IRA. The decedent was only 60. I assume the sole beneficiary will start taking distributions next year (mother passed in 2012) based on the beneficiary’s life expectency and the Single Life Table.
Permalink Submitted by Alan Spross on Mon, 2012-06-04 16:05
You are correct with respect to the inherited IRA.
For the ESOP, the distribution terms makes a qualified LSD for NUA purposes impossible. Even the last 20% could not be used because the triggering event is the plan owner’s death and the first distributions then become intervening distributions and the beneficiary will not have a new triggering event.
Note that the non spouse beneficiary cannot convert an inherited TIRA account, but COULD roll any or all of the ESOP distributions to an inherited Roth IRA. Beneficiary could also make a different decision regarding the type of inherited IRA for each year’s transfers.
Permalink Submitted by Jeffrey Moss on Mon, 2012-06-11 20:19
As an additional follow-up, when the ESOP makes future annual distributions to the beneficiary, I understand each year he can treat each differently. If he elects to continue the deferral by rolling the distributions to an inherited IRA, could he simply add these amounts to an inherited IRA he is currently setting up to receive his mother’s TIRA?
We are going to discuss Roths, but we will need to determine whether he can pay the taxes with non-IRA assets.
Thanks again – Jeff
Permalink Submitted by Alan Spross on Tue, 2012-06-12 01:00
Perhaps the 5 year distribution of the ESOP reflects a mandatory 5 year rule with respect to RMDs post death (employee passed prior to RBD). If that is the case, things get complex. A non spouse beneficiary can use life expectancy if the plan mandates the 5 year rule only with respect to transfers done before 12/31 of the year following the employee’s death. That does not appear possible if the ESOP proceeds can only be distributed over 5 years. The beneficiary cannot use life expectancy for the portion that can be directly rolled prior to that 12/31 and the 5 year rule for the rest. It’s one or the other for the entire balance.
If the 5 year rule applies (check with the plan administrator on this point), then direct rollovers to an inherited TIRA or inherited Roth IRA can be completed without RMDs until the final year. However, these IRAs are then subjected to the same RMD rules as the plan itself (ie 5 year rule). If this is the case, such direct rollovers must be made to newly established inherited IRAs since the other inherited IRAs will be subject to life expectancy and two different RMD provisions cannot apply to the same account.
If the plan provides an election for life expectancy, then each year the life expectancy RMD must be paid to the beneficiary and the balance directly rolled over to an inherited IRA which will also use life expectancy. As for all non spouse beneficiaries, any and all rollovers must be done directly.
Permalink Submitted by Jeffrey Moss on Sat, 2012-07-28 17:46
[quote=”[email protected]“]Perhaps the 5 year distribution of the ESOP reflects a mandatory 5 year rule with respect to RMDs post death (employee passed prior to RBD). If that is the case, things get complex. A non spouse beneficiary can use life expectancy if the plan mandates the 5 year rule only with respect to transfers done before 12/31 of the year following the employee’s death. That does not appear possible if the ESOP proceeds can only be distributed over 5 years. The beneficiary cannot use life expectancy for the portion that can be directly rolled prior to that 12/31 and the 5 year rule for the rest. It’s one or the other for the entire balance.
[u]If the 5 year rule applies (check with the plan administrator on this point), then direct rollovers to an inherited TIRA or inherited Roth IRA can be completed without RMDs until the final year. However, these IRAs are then subjected to the same RMD rules as the plan itself (ie 5 year rule). If this is the case, such direct rollovers must be made to newly established inherited IRAs since the other inherited IRAs will be subject to life expectancy and two different RMD provisions cannot apply to the same account.[/u]
If the plan provides an election for life expectancy, then each year the life expectancy RMD must be paid to the beneficiary and the balance directly rolled over to an inherited IRA which will also use life expectancy. As for all non spouse beneficiaries, any and all rollovers must be done directly.[/quote]
Alan – It appears there is no choice other than the five year payout. In addition to the ESOP, there is an inherited TIRA. The first ESOP distribution will be in December 2012. From what I am reading, rolling the ESOP distributions into the inherited TIRA will make a mess of this. Assuming I keep them separate, it appears that if we roll all 5 ESOP distributions into 1 additional inherited IRA, distributions an be delayed until all 5 distributions are taken, but then the balance would have to be distributed within 5 years after the last rollover. The option would be having 6 inherited IRA’s.
Any suggestions?
Permalink Submitted by Alan Spross on Sat, 2012-07-28 22:44
While you indicated that a 5 year distribution @ 20% per year is required by the ESOP provisions, that provision does not necessarily mean the 5 year rule applies with respect to RMDs from the plan. Did you ever determine what the plan indicates with respect to RMDs after death of the participant? Options are:
1) Life expectancy distributions
2) 5 year rule
3) Participant option if made before the end of the year following participant’s death.
The plan should address RMDs separately from the limitation of distributions to 20% per year.
Permalink Submitted by Jeffrey Moss on Sun, 2012-07-29 14:13
The plan document states the vested balance upon normal retirement age will be distributed over 5 years. There are 2 exceptions. One being small distributions which will be paid in a lump sum, and an exception for balances over $985K, when an additional year is added for each $195K over $985K. There is no provision for lifetime payments that I saw.
Alan-I sent you a private message.