Using After tax 401k contributions to reduce tax on NUA

Submitted by Howard Hook on Mon, 2015-09-07 17:01

Client (age 65) of mine has $1 Million in 401k consisting of the following:
Pre-tax $800,000
After-tax $120,000
NUA stock $ 80,000 (Cost basis of $20,000)

Original goal is to roll the pretax to a TIRA; roll the after tax directly to a Roth IRA and roll out the NUA and pay ordinary income tax using cost basis of $20,000 for the NUA.

Custodian has told the client they could eliminate any immediate tax due on rolling out the NUA by rolling $20,000 of the After tax dollars to TIRA (instead of the Roth IRA).

Does this sound correct? Custodian said this can now be done due to some recent tax law changes but is not done often since many clients do not have enough after tax dollars to be able to accomplish.

Thanks as always
Howard



Submitted by Bruce Steiner on Mon, 2015-09-07 21:26

  • The IRS allowed the basis to be allocated to the shares rolled over in PLR 8538062.  This was also the result in PLR 201144040.  However, there was no discussion of that issue in PLR 201144040.  The taxpayer in PLR 201144040 assumed that was the result, so he didn’t ask for a ruling on that issue.
  • On the other hand, the basis was prorated in PLR 200038050, and PLR 8426132 assumed that the basis would be prorated.
  • Bruce Steiner, attorney, NYC, also admitted in NJ and FL

 

Submitted by Alan - IRA critic on Tue, 2015-09-08 03:09

  • Cost basis of the employer shares for NUA purposes is a totally different form of basis than is represented by the after tax contributions made to the plan. The plan provisions in this case should determine how much if any of the after tax contributions have been allocated to acquisition of the employer shares. The client should ask the plan administrator how much of the after tax contributions will be used to reduce the taxable amount in Box 2a of the 1099R issued to report the distribution of the NUA shares. If at least 20k of after tax contributions will be allocated to the employer shares, then Box 2a will be NIL and the entire distribution of employer shares will not be currently taxable outside of any LTCG realized pursuant to NUA treatment when the shares are sold.
  • Conversely, if no after tax contributions are allocated to the employer shares, the 20k will be taxable as ordinary income unless client wishes to take the aggressive intrepretion of PLR 8538062, and accordingly rolls 20k worth of the employer shares into a TIRA within 60 days of receipt. That would leave 60k worth of shares (plus/minus market change to FMV) which would all be NUA. As outlined by Bruce Steiner, IRS reaction to this strategy is not predictable. One of the issues here is the final paragraph of Sec 402(c)(2) which indicates that the first dollars rolled over to an IRA are deemed to be the pre tax amount, and whether cost basis of employer shares can be aggregated or must be applied as a portion of each individual share. PLR 8538062 requires aggregation in order to work.
  • Custodian’s advice applies to the NUA cost basis, not to after tax plan contributions. The 20k custodian is referring to would be pre tax NUA cost basis (not after tax contributions) and would be contigent on attempting to apply PLR 8538062. This is risky, and if plan administrator can apply after tax contributions up to 20k to reduce the taxable cost basis, this risk would not be necessary.
  • Whatever value is left in the plan after a distribution of the stock, Notice 2014-54 can be applied in order to elect that the remaining after tax contribution balance be directly rolled to a Roth IRA, and the pre tax balance to a TIRA. There would be no current tax due for these direct rollovers. Essentially a distribution to the client of the employer shares is being paired up with the tandem direct rollovers to utilize both NUA and isolation of the remaining after tax amounts to the Roth IRA.
  • Client could also choose to disregard NUA entirely, and just use Notice 2014-54 for the entire distribution. 

Submitted by Howard Hook on Tue, 2015-09-08 22:43

Thanks Alan and Bruce. Very helpful as always. I believe that the Plan Administrator has told them that there is enough after tax funds that can be allocated to the acquisition of the NUA stock as Alan mentions in his first paragraph.As far as disregarding the NUA we did run some numbers and client will be in higher tax bracket in a few years when they reach age 70 1/2, does not expect to sell any of the stock anytime soon and will use the dividends the stock pays to help offset living expenses.Thanks again!Howard  

Submitted by Bruce Steiner on Tue, 2015-09-08 16:29

Alan raises a good point.  NUA treatment isn’t necessarily better than rollover, especially now that anyone may convert to a Roth (which generally adds substantial value) regardless of income.  It may be worth spending a couple of hours to run some numbers.

Submitted by [email protected] on Mon, 2016-08-15 15:55

we have a situatioin where the plan administrator is saying a couple of strange things – 1) that you cannot take after-tax and roll to a Roth IRA AND do NUA at the same time.  They appear to be referring to Notice2014-54 to support their position and 2) so, they are suggesting that they could send him the after-tax directly and do the NUA as part of the LSD, but would require a withholding on the after-tax amount to cover the 20% required for the NUA distribution.  I am so baffled, I don’t know how to approach them with the proper choices.Am I missing something?  I hadn’t ever heard of a 20% withholding on a NUA transaction…..Suggestions on how to quote IRC and Notice 2014-54 in a manner that will allow us to do the following – Post 1986 After-tax amount = $60k.  Want to move that directly to Roth IRA – trustee to trusteeEmployer securities = $60k with acquisition basis of $200k.  Want to take as NUA, paying ord inc on 200k.Pre-tax mutual funds = $200k.  Want to move to TIRA – trustee to trustee.Help?

Submitted by Alan - IRA critic on Mon, 2016-08-15 18:34

There is no mandatory withholding for any of the components of employer shares distributions per Sec 3405(e)(8) as follows:

(8) Maximum amount withheld

The maximum amount to be withheld under this section on any designated distribution shall not exceed the sum of the amount of money and the fair market value of other property (other than securities of the employer corporation) received in the distribution. No amount shall be required to be withheld under this section in the case of any designated distribution which consists only of securities of the employer corporation and cash (not in excess of $200) in lieu of financial shares. For purposes of this paragraph, the term “securities of the employer corporation” has the meaning given such term by section 402(e)(4)(E).

Submitted by David Mertz on Mon, 2016-08-15 18:44

The instructions for box 4 of Form 1099-R further clarify section 3405 with regard to this, indicating that the withholding cannot exceed the amount of cash and property other than employer securities distributed that are not directly rolled over.  If the portion not directly rolled over consists only of employer securities (the NUA shares), there should be no withholding.

Submitted by David Mertz on Mon, 2016-08-15 18:47

Also, Notice 2014-54 makes no mention of NUA.

Submitted by Alan - IRA critic on Mon, 2016-08-15 19:13

m- not sure I understand the totals of plan components here. After tax contributions is apparently 60k. What is total value of employer shares and what is the NUA cost basis portion of the total value of the employer shares? Finally, is 200 k the total value other than employer shares? It sounds like if the after tax amount could be rolled to a Roth IRA, the cost basis of the NUA shares might be such a high % that NUA would not be worth considering. One consideration that might be possible here is that an LSD does not require a single distribution, but Notice 2014-54 DOES require a single distribution with all parts requested at the same time and distributed at the same time or close to it. Therefore, of the NUA shares were distributed first as a separate request (this also gets a separate 1099R), how does the plan accounting assign after tax contributions to the shares? For example, if the plan pro rated the 60k after tax amount to the NUA shares and that came to 20k, then there would be 40k left to direct to a Roth IRA as part of a Notice 2014-54 twin direct rollover request to complete the LSD. The Notice has some examples of single distributions where some portion goes to the participant, and that portion would appear to include company shares. That would result in the pre tax money being applied to the direct rollovers, reserving the 60k to apply to the NUA cost basis. This might be what the plan is stating, and why it might be best NOT to order the entire plan distributed in a single distribution, or best to forget about the NUA. Can you clarify that breakdown of the plan balance?

Submitted by [email protected] on Mon, 2016-08-15 20:55

Sorry, I mistyped one piece, here’s the correct breakdown -[Post 1986 After-tax amount = $60k.  Want to move that directly to Roth IRA – trustee to trustee] ;[Employer securities = $600k with acquisition basis of $200k.  Want to take as NUA, paying ord inc on 200k.] ;[Pre-tax mutual funds = $200k. Want to send Trustee to trustee to TIRA]-m

Submitted by Alan - IRA critic on Tue, 2016-08-16 02:07

  • m- now the numbers take on a more typical breakdown. NUA cost basis is 33.3% which is not particularly compelling unless client needs to use retirement money for expenses due in near future. If client wants to roll 60 k to a Roth IRA and take the employer shares for NUA, Dmx is correct that in most cases his tax bill will be the same, since a tax free Roth rollover would be offset by an increased cost basis for the employer shares, or vice versa. Therefore, for the 2 1099R forms, the Box 2a taxable amounts should total 200k either way.
  • If the client separated prior to 55, it would be better to have the after tax contributions on the NUA 1099R because that would reduce Box 2a in a case where 2a would be subject to the 10% penalty. However, as DMx stated, if the Roth rollover was taxable and the rollover was withdrawn before 59.5 and 5 years, there would be a 10% recapture tax on the pre tax rollover portion distributed from the Roth IRA.

Submitted by [email protected] on Tue, 2016-08-16 12:39

sorry to ask, but could you provide guidance on specific code references to give to plan administrator so that we could do the desired?  How do I show them that the IRC allows moving the after-tax balance to the Roth while taking employer securities as NUA and the rest to a TIRA?

Submitted by David Mertz on Tue, 2016-08-16 17:32

  • As I mentioned below, I think the plan is correct that, if some portion is not rolled over (the NUA shares, in this case), it is not possible to apply all of the after-tax basis to the rollover to the Roth IRA no matter how the rollovers are performed.  This is because the amounts rolled over come first from the pre-tax portion (by statute, the last sentence in section 402(c)(2)).  In other words, until ALL of the pre-tax portion is rolled over, NONE of the after-tax portion can be rolled over.  The result is that the only portion of the after-tax basis that could be applied to the rollover to the Roth IRA is any portion left over after after-tax basis is applied to the NUA.
  • With the numbers that you provided, all of the after-tax basis must be applied to the NUA shares since the after-tax basis is less than the NUA share basis.  With $200k rolled to a traditional IRA, $60k rolled to a Roth IRA and $600k of NUA shares distributed of which $400k is NUA, the entire $60k rolled to the Roth IRA will be taxable but only $140k of the NUA distribution will be taxable, for a total of $200k includible in income.  The Form 1099-R for the distribution of the NUA shares will have $600k in box 1, $140K in box 2a, $60K in box 5 and $400k in box 6 (and there is no withholding required since it is only employer shares that are not being directly rolled over).  The Form 1099-R that shows the direct rollover to the Roth IRA will have $60 in box 2a.  Even it it *was* possible to apply the after-tax basis to the rollover to the Roth IRA, the total taxable amount would still be $200k.

Submitted by [email protected] on Wed, 2016-08-17 13:56

Your first point confuses me with what I thought was the purpose of Notice 2014-54, which I thought was to clarify the ability of sending after-tax account values to Roth IRAs (the earnings of that separate after-tax account to TIRA) as opposed to having to pro-rate the distribution.  You seem to be saying that even with that clarification notice, the pre-tax goes first.

Submitted by David Mertz on Wed, 2016-08-17 15:23

  • Notice 2014-54, which conforms to the section 402(c)(2) requirement, indicates that *all* pre-tax money must be rolled over before any after-tax money can be rolled over.  This means that the after-tax basis must first be applied to the portion not rolled over.  Only after the after-tax basis has been applied to all of the portion not rolled over can any remaining amount of after-tax basis be applied to a portion that is rolled over.
  • You might be able to get some of the after-tax basis applied to the rollover to the Roth IRA by making the distribution of the NUA stock after the distribution and rollover of the other plan assets (but still all distributed within one taxable year).  In your example, the after-tax basis represents 7.5% of the plan assets.  By making separate distributions, 7.5% ($15k) of the $200k of other plan assets distributed and rolled over would be after-tax basis which could be applied to the portion rolled over to the Roth IRA.  The remaining $45k of basis would still be applied to the subsequent distribution of NUA shares.  (This begs the question, though, what would happen if the cost basis of the NUA shares was less that the after-tax basis that remained after the distribuiton of the other plan assets?  Perhaps Alan has some thoughts on this.  [Edit]  Alan has previously commented on the situation where after-tax basis exceeds NUA share cost basis, and his supposition makes sense to me:  https://irahelp.com/forum-post/12553-lsd-nua)

Submitted by [email protected] on Wed, 2016-08-17 21:36

Ok, how about this – according to Alan in a prior post –  [forum-post/25847-after-tax-401k-rollover] a participant could simply request to take the separate after-tax account out (assuming plan allows) and transfer the taxable earnings to a TIRA while transferring the after-tax basis to a Roth IRA, under Notice 2014-54.  So, can we do what we want by having this happen first, say in September and then once the seperate after-tax account is empty and moved as above, in Oct/Nov request a final total distribution whereby the pre-tax mutual funds are moved to a TIRA and the employer securities are sent via NUA treatment?  Any prohibition to this multiple step process to achieve the desired outcome – after-tax basis to Roth, pre-tax mutual fund to TIRA and employer securities via NUA to NQ account (only tax liabilty associated with acquisition cost ‘basis’). -m

Submitted by Alan - IRA critic on Wed, 2016-08-17 22:52

  • That might work as long as the first distribution is clearly limited to the after tax sub account under Sec 72(d)(2), which the tax code indicates can be distributed separately. In other words, if this portion of the plan can be distributed separately and there is no prohibition for doing that, the after tax amount would not be pro rated against the entire balance of the plan not being distributed during the specified distribution. You did not break out the earnings in the after tax sub account, but it is probably a modest amount and would go in a direct rollover to a TIRA, the 60k itself would go to the Roth IRA as part of that same Notice 2014-54 distribution. Note that the belief that the separate sub account treatments end at separation is wide spread, but there is no reason that the sub account does not continue. But there could be resistance. Or their tax Dept might do the 1099R wrong because this particular distribution can be reported on the same 1099R as the rest of the account ex employer shares. It is critical that they report nothing in Box 2a on that particular 1099R.
  • Did you catch that the taxable amount for the LSD year will be the same either way? In other words, if the after tax amount all goes to the Roth IRA, then 200k will be taxable for the NUA cost basis. Either way, there will be a total of 200k in taxable income from all these distributions.
  • Note that employer shares do not ALL have to distributed for NUA. For example, if client chose to use NUA on only 1/3 of the employer shares, and roll the rest to a TIRA where they could be sold to get instant diversification, then only 66,667 would be the taxable cost basis instead of 200k. That reduces taxes considerably and reduces continued exposure to 600k worth of a single issue. Of course, the trade off is that there will be roughly 267k more in the IRA to eventually be taxed at ordinary income rates. Note that there is no death basis adjustment on NUA.

Submitted by [email protected] on Thu, 2016-08-18 18:41

Yes, I do realize that the current year tax liability will be the same.  Thank you both for your detailed responses to help me understand.  I like to try to keep things simple, so since the plan admin says they will allocate the after-tax basis to the acquisition cost basis of the employer shares, we will recommend requesting the NUA and roll all the rest to a TIRA and go from there.  Thanks again, -m

Submitted by David Mertz on Mon, 2016-08-15 19:42

Ah yes, Notice 2014-54 says that the pre-tax amount is first applied to the portion directly rolled over.  This would mean that the some or all of the after-tax money would be applied to the portion not directly rolled over, which in the proposed distribution would be the NUA shares.  Even if there was a distribution paid to the participant (with taxes withheld), amounts rolled over (the amounts other than the NUA shares in this case), would come first from the pre-tax portion whether rolled to a traditional IRA or to a Roth IRA.  I don’t see how the entire after-tax portion could be rolled to a Roth IRA while keeping the basis in the NUA shares taxable.

Submitted by David Mertz on Mon, 2016-08-15 19:50

Actually, it doesn’t matter that some or all of the after-tax portion is applied to the NUA shares.  The amount of the NUA basis that is excludable from income as a result of being after-tax offsets the amount of the Roth rollover that is includible in income because it is pre-tax.  (Although, it *would* matter if an early distribution of the portion moved to the Roth IRA was desired before the expiration of the 5-year holding period; the portion of the direct rollover to the Roth IRA that was taxable would be subject to an early-distribution penalty.)

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