59 1/2 starts when to avoid 10% early withdrawal penalty

Submitted by Vickie Intriago on Tue, 2020-12-08 07:06

Client’s birthdate is June 1, 1961. She is considering a substantial withdrawal from her 401k plan to purchase a manufactured home. I have convinced her to Rollover to an IRA to avoid the 20% withholding. I also advised her to maybe withdraw some of the money by end of year 2020 and the remaining amount in 2021 to spread out the tax consequence.

The amount is $350,000. My question is if she takes funds out this year in 2020 will the 10% early penalty be assessed? Or, when is the exact date she turns 591/2? How strict is IRS looking at this age?

Please advise.



Submitted by David Mertz on Tue, 2020-12-08 12:39

The IRS strictly allows the age-59½ penalty exception beginning on the exact date one reaches age 59½.  In this case, any distribution she takes in December 2020 would qualify for this exception.  The payer *should* use code 7 on the Form 1099-R for distributions on or after the date the individual reaches age 59½, but if they don’t, the portion received after reaching age 59½ reported on a code 1 Form 1099-R can be claimed on line 2 of Form 5329 with the code-12 (Other) exception.

Submitted by Alan - IRA critic on Tue, 2020-12-08 14:27

  • Whle she could avoid withholding by doing a direct rollover to her IRA, then taking the distributions from the IRA, if she has no withholding she will probably have a large tax bill when she files, and could also have an underpayment penalty if she does not meet one of the safe harbors. 
  • Since she will be spending this amount right away, she should check if she has highly appreciated employer stock shares in the plan, eligible for NUA treatment and the lower LTCG rate if she makes a lump sum distribution, where the shares are transferred to a taxable brokerage account. Distribution timing is critical if she utilizes NUA and also wants to split the tax impact of the distribution over 2 years.

Submitted by Vickie Intriago on Tue, 2020-12-08 23:09

Thank you for reminding me about the NUA. She is the ideal client with over $200,000 of gains in her AMGEN Stock.  Now, finding a CPA/accountant that is aware of this special tax rule is something else.  So, in the meantime, I am setting up the brokerage account for her to move the Shares.  If shares arrive next week to the account and she sells within days, is this taxed as a long term capital gain?  I want to make sure.This Do It Yourself client did not mind paying my fee for advice when I gave her this gem of a recommendation. She wanted to go to the Fidelity counter.  Thanks for making me look like a genius!

Submitted by Alan - IRA critic on Wed, 2020-12-09 02:34

  • Yes, the excess of value per company share over the cost basis (value of shares when contributed to 401k account) will be taxed at LT cap gain rates. If there is an additional gain after distribution, that portion of the gain will be taxed at ST cap gain rates (same as ordinary income rates). 
  • Remember, to qualify for NUA she has to complete a qualified lump sum distribution in which the entire balance of the 401k and similar plans such as any ESOP plan must be distributed by year end. Typically, this means that the non employer shares must be rolled in a direct rollover to an IRA.  If there is any doubt about getting the LSD completed, it could wait until January where there would be plenty of time to complete the LSD in 2021. It will still be challenging to navigate all this and use 2 taxable years to split the income.
  • One way to do that would be to take a 401k distribution this month of the non employer shares. That would be 2020 taxable income. In January, the NUA shares could be distributed, and any remaining balance in the 401k rolled to an IRA or distributed. The main thing to remember is that the year in which the shares are transferred to the brokerage account is the year in which the entire plan balance must be drained in order to satisfy the qualified LSD requirment for NUA.
  • Does she have any after tax (non Roth ) contributions in the plan?

Submitted by David Mertz on Wed, 2020-12-09 03:08

Since that the client has already reached age 59½ and assuming that the NUA-qualifying event was reaching age 59½, it seems to me that a distribution of non-employer shares now in 2020 without distribution of everything else in 2020 would disqualify NUA treatment based on the age-59½ triggering event because it would no longer qualify as a lump-sum distribution.

Submitted by Alan - IRA critic on Wed, 2020-12-09 14:24

  • Good point. That 2020 distribution would be an “intervening distribution” done after the triggering event and before the LSD year (2021). This could only be countered if she has not yet separated from service, takes the 2020 non NUA share distribution, then retires (new triggering event), all before the end of the year, then completes the LSD in January. Probably not in the cards. However, if she is able to complete the entire LSD before year end 2020, it would qualify and she would be taxed only on the cost basis without penalty. She could then sell the shares in the brokerage account in January and would owe the tax on the LTCG in 2021. That would split up the taxable income somewhat depending on what the cost basis is. To raise the entire 350k, she might have to take a distribution from the rollover IRA.
  • Again, be sure to AVOID an intervening distribution, but also get assurance from the plan that they can complete the LSD this year. It is always a good idea to confirm with the plan that the distribution will be reported with the cost basis in box 2a, and NUA in Box 6, ie qualifies as an LSD.

Submitted by Vickie Intriago on Thu, 2020-12-10 03:04

The goal is to process the lump sum distribution in 2020.  We have the brokerage account set up to receive the shares electronically within 5 business days.  The remaining 401k balance of non company shares will be FEDEXED to IRA same week.  Her plans are to then sell some of the AMGEN shares and pay LTCG on the earnings in 2020.She doesn’t need to sell all of her AMGEN does she?    You mention in last step that she could sell shares in January 2021.  Can she sell the shares in 2020 and still qualify for NUA treatment?  Also, do you have a CPA /accountant referral in Torrance, CA 90503 area that I could discuss this with?  I cannot find accountants that are aware of the NUA treatment.

Submitted by Vickie Intriago on Thu, 2020-12-10 03:06

Above client separated from AMGEN 7 years ago.  Does she still qualify for NUA treatment?

Submitted by Alan - IRA critic on Thu, 2020-12-10 03:41

  • She can sell a portion of the shares this year and the rest in 2021 or later. I assume she knows what her cost basis is per share and accordingly what her NUA is per share. As for the LSD, since she just reached 59.5, that is her most recent triggering event. Even if she took a distribution in the past, those do not matter since reaching 59.5 erases any past distributions. Her separation date therefore no longer matters.
  • Can’t help with the CPA referral. NUA is not that rare it should be that hard to find a CPA familiar with it. Best to look in a higher income zip code, although Torrance is large enough that a CPA there who is not well versed should know one who is, given their continuing education requirement meeting of the past.
  • Once the shares reach the brokerage account, contact the broker and provide the cost basis per share before sale, so the 1099B will be correct in January. If it is incorrect, it is till possible to correct the basis on Form 8949 so the amount of LT gain is correct. As for the 1099R, if it is correct all the accountant has to do is enter it into their tax program, and the amount in Box 2a will be taxed as ordinary income. Note that if she any after tax contributions in the plan, some plans will automatically apply that to reduce the taxable box 2a amount, others may allow her to apply the after tax amount to a split rollover where the after tax amount goes to her Roth IRA (tax free), and the rest of the pre tax non stock amount goes to a TIRA. If she has more than a very small after tax amount (should show on her statement), she should ask what her options are for applying it to the distribution.

Submitted by Vickie Intriago on Wed, 2020-12-30 20:00

I convinced my client is this example from weeks ago, to complete the NUA in 2021.  She will be 59 1/2 and we have 2021 to complete transaction.  However, the 401k provider gave us a lump sum amount as a cost basis.  You mention in your previous response that we should know our cost basis per share.  Ifh she doesnt have the breakdown can we still do the NUA?  Thank you so much 

Submitted by Alan - IRA critic on Wed, 2020-12-30 20:33

Since she reached 59.5 on 12/1/2020, which is a triggering event for NUA, hopefully she has not taken any distribution from the plan this month since that would derail a lump sum distribution for next year. 
The lump sum given divided by the total current value of the shares will provide the cost basis %. Client can figure her own breakdown as follows.  Generally, NUA is not beneficial if the cost basis is over 30% of the current value. If the NUA (gain) is 200k, then the cost basis should not exceed 80k  (80/280=28.6%). The cost basis will be taxable in the year of distribution (2021), and will not be subject to penalty since she is over 59.5. If there are any after tax contributions being used to reduce the cost basis being quoted, she should get a breakdown of that.
The 1099R will just show gross numbers, not per share numbers. But she will need to know the per share cost basis when she reports the eventual sale of the shares. Of course, she must complete the entire rollover of the plan balance in 2021 including non employer shares generally rolled to an IRA in order for the lump sum distribution to be qualified for NUA purposes.  She has the entire year to complete the LSD, so no immediate time pressures. 

Submitted by Vickie Intriago on Tue, 2021-01-05 03:35

I am back again.  I was intrigued by last remark where you mention that NUA is not beneficial if Cost basis exceeds 30%.  Why is that?  At the moment the basis is 32% of the current value.  Is that because the cost basis amount of $100,000  in addition  to her salary income puts her in  the 32% tax bracket?  Cost basis is $100,000 and current value of AMGEN Stock is $313,000.  Although, it’s probably less today since stocks dropped in value today.

Submitted by Alan - IRA critic on Tue, 2021-01-05 03:57

There are many factors, and they effect participants differently. 30% is just a rough figure, but it can be ignored if the participant needs the funds for immediate spending need anyway and would have to take a distribution. In that case, better to pay cap gain rates on the NUA than ordinary income.
But the typical participant does not need a large distribution for current spending. If the cost basis is high current taxes are due on that basis at full ordinary rates and tax deferral is lost. It is also lost on any future dividends declared on the shares. Even worse if under 59.5 and the 10% penalty is due.  Doing the LSD presents a problem with diversification, so if the participant wants to unload a number of shares, the cap gain rate is also due, and while the rate is lower, AGI can still rise enough to trigger  other costs such as IRMAA, NIIT, etc.  If participant passes with NUA shares, there is no step up in basis for the NUA amount for the beneficiary. Following is an extensive article on NUA and determining the balancing point at which basis is too high to make NUA a beneficial option. Examples are included.
 401(k) Net Unrealized Appreciation (NUA) Rules And Caveats (kitces.com)

Submitted by Vickie Intriago on Wed, 2021-01-06 17:18

If client’s account purchased more shares of AMGEN stock in last quarter of 2020 because the dividend reinvest option was turned on,  will client still get favorable long term capital gain treatment if those shares are transferred to brokerage account this week and sold ?  I seem to think yes.    You were right about not requesting this move at end of year.  IT has not been easy to do this with several people at Merrill Lynch doing this.

Submitted by Vickie Intriago on Mon, 2021-01-11 19:54

Shares of the AMGEN Stock are in transit to complete the first half of the NUA transaction.  In December the shares issued dividends which were reinvested. So, the cost basis increased by $2,000.  My client plans to sell her shares of AMGEN  stock as soon as they hit the brokerage account.  My question is if the latest $2,000 that was paid out in December and bought more shares of AMGEN, do those shares receive the special Long term capital gain treatment when she sells in January 2021?  

Submitted by Alan - IRA critic on Mon, 2021-01-11 20:49

Most companies use an average cost basis of all the shares including those purchased through dividend reinvestment. Therefore, this reinvestment cost basis increase will be spread over all the shares and the total value of the shares will increase by 2000, the cost basis by 2000, while the NUA amount remains the same. Effectively, for the LSD her cost basis will rise 2000 on her 1099R Box 2a. Upon sale of the shares in her brokerage account, assuming no investment gain or loss, her NUA will be the same as before the reinvestment, and the LTCG will be the same. Therefore, recent dividends add only to cost basis. If these dividends have been reinvested for several years, they tend to water down the cost basis % by adding to cost, while the more recent shares purchased have not had the time to appreciate like the older shares. All NUA will still receive the LTCG rate on all shares sold, even the ones just purchased.

Submitted by Dave Johnson on Tue, 2021-01-05 23:23

Client has a pension and a 401K. Can he rolelover the pension into 1 IRA and the 401K in a seperate IRA?He is 55 so wondering if he could take substantial equal payments from he Pension after it is rolled into his IRA and avoid the 10% penalty.  Thanks

Submitted by Alan - IRA critic on Tue, 2021-01-05 23:43

If he separated from service in the year he reached 55 (probably 2020), any distributions taken directly from the plans of this employer will be penalty free, avoiding the hassle of a 72t plan.  If he separated earlier, or if these plans only offer lump sum distributions, then he  would likely need to set up a 72t plan with an IRA. If he does direct rollovers to an IRA, he might as well roll both plans into the same IRA. He could then figure the exact balance he needs to generate the needed funds to get him to 59.5, and then transfer that balance into a new IRA used to set up the 72t plan. But if he needs the entire balance for the 72t plan, it could just be set up with the IRA holding both direct rollovers without the need for a second IRA account. 

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