NUA and After-Tax Contributions in 401k Plan

Submitted by Todd Kirsch on Fri, 2018-10-19 22:27

I have a client who has $2.2 million in his 401k. Of this, approximately $600,000 is held as highly-appreciated company stock – he is a candidate for NUA tax treatment. He is 60 years old and wants to retire in 2-4 years. He also has after-tax contributions in his 401k plan. His plan allows in-service distributions. So there are two issues/opportunities: NUA and after-tax contributions being rolled to a Roth IRA. There could be an advantage to moving his 401k funds to an IRA – but leave the company stock in the plan. However, I think that might destroy the ability to roll the entire amount of the after-tax funds to a Roth IRA. Is that true? Second, will an in-service distribution of all funds except his company stock compromise his ability to claim the NUA tax treatment when he retires? Is there anything else we should be considering? Thank you.

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Permalink Submitted by Alan - IRA critic on Sat, 2018-10-20 00:42

His triggering event for NUA will be separation from service, and he does not get another such event before his death. Therefore, in order to utilize NUA he must avoid “intervening distributions” which are distributions following the triggering event (separation) in a year prior to the LSD year. He can take a distribution PRIOR TO separation from service which could be a split distribution of the after tax sub account per Notice 2014-54 in which he directs the after tax contributions to his Roth IRA and the gains on those contributions to a TIRA account. That will get his after tax amount into a Roth and still preserve the NUA opportunity for later. After separation he will have complete his LSD of the entire balance of the plan in a single year in order to avoid an intervening distribution.
As for NUA benefits, it is usually not beneficial if the cost basis is more than 25% of the FMV of the shares at the time of distribution.
If the above plan does not work well for him, perhaps because he lacks the money to pay the additional tax on the cost basis of the NUA shares or some other reason, plan B would be to have the plan apply the after tax amount to reduce the taxable cost basis of the NUA shares, which is probably what the plan will do if the after tax amount is still in the plan when the shares are distributed. He would have to crunch the numbers to determine which of the two options (Roth vs reduction of taxable cost basis of NUA shares) for applying the after tax amount is most beneficial.
To be clear on your final question, an in service distribution will not impair NUA, but a post separation distribution in a year prior to the LSD year will.
The combination of NUA potential with after tax contributions creates a complex planning situation as you can see. Usually the choice is just NUA vs rollover, but the after tax amount creates a third pot that must be incorporated in the planning process. Once the best approach is determined, client should check with the plan administrator to be sure there are not any plan provisions that interfere with the plan.

Permalink Submitted by David Mertz on Sat, 2018-10-20 01:20

In bullet #2, I think that Alan meant to say that it is usually not beneficial if the *cost basis* is more than 25% of the FMV of the shares at the time of distribution.

Permalink Submitted by Bruce Steiner on Sun, 2018-10-21 13:32

Roth conversions often add substantial value. Now that there is no longer an income cap for eligibility to convert to a Roth, the rollover will be better than the NUA more often than before. Of course, there will still be cases where NUA will still be preferable to rollover.