IRS closes NUA tax loophole

The Internal Revenue Service has closed another loophole in the Tax Code. This time, it involves the tax break known as net unrealized appreciation in employer securities. Depending on the appreciation of the company stock an employee has in his or her 401(k) plan, the tax break can save thousands or even hundreds of thousands of dollars in taxes.

To qualify for the NUA tax break, an individual must have company stock in his 401(k) account. Once the employee leaves the company, he or she can elect to withdraw the company stock and transfer it as stock (“in kind”) from the plan to a taxable brokerage account as part of a qualifying lump-sum distribution.

This means that the entire account balance must be withdrawn from the plan in one calendar year.

The distribution can only qualify if it is done after the employee has a “triggering event.” Triggering events are separation from service, reaching age 591/2, death or a disability.

In a qualifying distribution, any non-company stock can be transferred to an individual retirement account, and if there is significant appreciation in the stock, it can be transferred to a taxable brokerage account. The employee pays tax only on the cost of the shares when they were purchased in the plan.

The appreciation in value (the net unrealized appreciation) isn’t taxed on the transfer. When the shares are eventually sold, they are taxed at long-term capital gains rates.

This can be a huge advantage, compared with the tax that would be paid if the shares were rolled over to an IRA, where future withdrawals would be taxed at ordinary income tax rates — which can be more than double the capital gains rates.

Under the Pension Protection Act of 2006, beginning last year company plan funds could be converted directly to Roth IRAs. That led some to think that the Tax Code had created a loophole if company stock was converted to a Roth IRA as part of a qualifying lump-sum distribution.

It appeared that the NUA amount (which wouldn’t be taxed when the stock is withdrawn from the plan) would never be taxed if it was transferred to a Roth IRA as part of a conversion of the plan funds. That sounded too good to be true and the IRS has now confirmed that.

Recently released IRS Notice 2009-75 stated that a rollover of funds from an employer plan to a Roth IRA is a conversion, just as a rollover from a traditional IRA to a Roth IRA is a conversion. The company plan funds (including the NUA stock) are treated as though they are first rolled over to a traditional IRA that is the taxpayer’s only IRA, and then converted to a Roth IRA.

For example, let’s say that Sam has a 401(k) plan with a balance of $250,000. There are no after-tax funds in this account.

The 401(k) includes shares of company stock with a market value of $200,000. Their basis (the cost of the shares to the plan) is $75,000.

Sam moves the entire $250,000 401(k) balance to the Roth IRA.

Now, if the shares of company stock were distributed to him directly, as part of a qualifying lump-sum distribution, he could elect to use NUA treatment on those shares. Sam would owe income tax on the basis amount of $75,000 for the year of the distribution.

If the NUA is $125,000 (the balance of the value of those shares, $200,000 – $75,000 = $125,000), he would owe no tax on the NUA until those shares are sold. When sold, the NUA is taxed at favorable long-term capital gains rates, which could produce a substantial tax savings for Sam.

However, since he moved those shares to a Roth IRA and that transaction is treated as if the shares were first rolled to an IRA and then converted to the Roth IRA, he will pay income tax on the total amount of his conversion, $250,000. Sam can’t use NUA treatment because the shares of the company stock went into the Roth IRA and not a taxable account.

Some plan participants have been advised that they could move their 401(k) balances to a Roth IRA and use NUA treatment. They thought that a loophole in the Tax Code allowed the NUA to escape income tax forever, because the funds are now in a Roth IRA.

The IRS has now made it clear that this won’t work. Once the employer stock is rolled over to an IRA or converted to a Roth IRA, the NUA tax break is irrevocably lost.

The employer stock will be taxed at ordinary income tax rates upon conversion, the same as other plan or IRA funds that are converted to a Roth IRA.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.

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