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1. Quick Draw McGraw
Some advisors and financial institutions are a little too quick on the draw with IRA rollovers. While there are clear advantages to rolling over your company plan lump-sum distribution to an IRA, as an advisor, you must first ask your client if there is any company stock in their 401(k) and see if there is any appreciation. Once you roll the company stock to an IRA, the NUA tax break is lost forever because this is an irrevocable election. IRS made that clear in PLR (Private Letter Ruling) 200442032, released by IRS October 15, 2004. In this case, the taxpayer made the fatal error of doing an IRA rollover and then realized that he had highly appreciated company stock. He requested a ruling asking IRS if they would let him revoke his IRA rollover election and allow him to treat the company stock as if it were distributed to him personally so the stock would qualify for NUA treatment. IRS said “No” because the rollover election was irrevocable. Once in the IRA, the company stock will no longer qualify for the NUA tax break.

IRS stated, “This election is irrevocable. …Therefore, the eligible rollover distribution is not eligible for the exclusion from gross income for net unrealized appreciation on employer stock.”

If you intend to qualify for the NUA tax break on a lump-sum distribution from your company plan, make sure that you DO NOT roll the company stock to an IRA. If you do that, the NUA tax break will be irretrievably lost.

2. Not Going All the Way
A lump-sum distribution means that ALL of the company plan funds must be distributed in one calendar year. If there is any balance in the plan at the end of the year, clients lose and will blow the NUA tax break. This does not mean that they must pay tax on all of the plan funds withdrawn. Clients can roll the non-company stock plan funds over to an IRA. They can even roll some of the company stock over to an IRA if they do not want to pay tax on the cost of all the shares withdrawn. But whatever clients do, they must go all the way, emptying the entire plan balance in one tax year. Close is not good enough, as one sorry taxpayer found out in 2004 in PLR 200434022, released by IRS August 20, 2004.

Advisors must monitor all lump-sum distribution attempts to make sure that the plan balance is zero at year-end, otherwise the consequences will be costly. Do a post-transfer checkup and do it before the year ends to make sure that all funds have been withdrawn from the plan within the year. Another tip is not to begin an LSD too late in the year because there are always delays and these transactions usually take some time. Start the process early in the year and as a rule, never start this after Thanksgiving. It is unlikely all the plan assets will be withdrawn by year-end.

3. Failing the LSD Test with RMDs and Other Distributions
Certain distributions, like required minimum distributions (RMDs), 72(t) distributions and in-service distributions, taken after a triggering event, like retirement, can kill the NUA tax break. Remember that the entire plan balance must be withdrawn in one calendar year after a triggering event.

For example, some employees retire but choose to leave their funds in the company plan. Then they reach age 70½ and must begin taking RMDs from the plan. A plan participant who retires in 2011 and takes his first RMD in 2012, and then takes a lump-sum distribution from the plan in 2013, no longer qualifies since he failed the LSD test. The withdrawal of the remaining plan balance in 2013 does not qualify as an LSD since he took an RMD in 2012. The LSD must follow a triggering event, such as retirement. The 2013 distribution did follow the 2011 retirement, but the 2012 RMD killed the NUA break. The only way the NUA break could be salvaged is if there were another triggering event after the 2012 RMD was taken, such as death or disability, and then the plan balance was withdrawn all in some later year.

4. Selling Out
Don’t sell out too quickly. Most companies, thankfully, are not like Enron. After the Enron publicity, the media hit us with an overdose of stories about the dangers of keeping too much company stock in your 401(k) plan. As a result, many employees got scared and sold their company stock without even checking to see if the stock had appreciated from the amount they paid for it in the plan.

Once they sold those shares in the plan, they killed the NUA break on the appreciation to date. Some employees later came to their senses and bought the company stock back in the plan, but now they have a much higher basis and unless there is a huge increase in the value of those shares by the time they retire they will have blown the NUA tax break. Advisors have reported cases to us where employees who worked for 20, 30 years or more sold stock in a panic, even though they were sitting on 20 and 30 years of appreciation.

Advisors should talk to their clients about NUA and keep track of the basis on the company stock at least annually and advise clients nearing retirement (especially those with highly appreciated company stock in the plan) not to sell the shares until after they retire and complete an LSD. This way, they can take advantage of the NUA deal and after that, if they wish to diversify, they can sell the shares and pay only the capital gains rate. Even if the client is not near retirement, you, as the advisor, should still inform him or her of the benefit of holding the stock for the NUA break at retirement. You don’t want a client saying “Why didn’t you tell me about this before I sold the stock” after the damage is done.

Of course, every case stands on its own facts and circumstances. If a client is truly concerned about the future of their company while they are still in the plan and fears the stock may tank, then obviously you would not want them to hold on just for the NUA. If the stock does take a dive, then there won’t be any NUA anyway.

5. Not Telling Beneficiaries About NUA
NUA is not just for plan participants. Beneficiaries get it too. But most people don’t know this and beneficiaries miss out. If your client is in a 401(k) plan and dies with the funds still in the plan, the beneficiary can claim the NUA tax break on an LSD.

This is more common than you may think. If your client, for whatever reason, dies while the funds are still in the 401(k) plan, and the beneficiary is a child or grandchild (or any non-spouse beneficiary) the plan will probably not allow a lifetime payout over the beneficiary’s life expectancy (like the stretchout from an inherited IRA). The plan must now offer the beneficiary the option to do a direct rollover to a properly titled inherited IRA. But if the beneficiary takes a lump-sum distribution, then the beneficiary will owe all the tax at one time, ending the tax deferral. That’s because a non-spouse beneficiary cannot do a rollover so once the funds are distributed they are all taxable.

If there is company stock in the plan, the beneficiary qualifies for NUA treatment the same as the plan participant would have, had he or she lived to take the LSD. This may save the non-spouse beneficiary a ton of tax, plus the tax on the NUA can be deferred until the stock is sold. When the stock is sold, the beneficiary must pay the tax since there is no step-up in basis for NUA, but the beneficiary still pays only capital gain rates on the NUA.

The NUA break also applies to a spouse beneficiary if he or she so chooses. A spouse can do an IRA rollover, so that surviving spouse can transfer the shares to a taxable account and roll the other non-company stock funds over to an IRA, the same as the plan participant could have done had he or she lived to take the LSD. If the appreciation is not enough to make it worthwhile to pay tax on the cost of the shares now, then the spouse can roll some or all of the company stock over to an IRA and extend the tax deferral until he or she is subject to RMDs in the IRA. But once that choice is made, any NUA stock rolled to an IRA no longer qualifies for the NUA tax break.

Advisors need to alert all plan beneficiaries to the availability of the NUA break.

IRS Allows Basis of Company Stock to Stand After Corporate Spin-off and Reoganization

PLR 200927040
Released by IRS on July 3, 2009

With all the mergers, acquisitions, spin-offs and corporate reorganizations, it is good to know that the basis of company stock that qualifies for the NUA tax break will not be changed or lost because of the corporate reorganization.

In this ruling, and in others, IRS confirms that the basis of the company shares are not affected by either a spin-off or reorganization, even when the companies are no longer members of the same controlled group after the reorganization.

When your clients leave a plan, make sure they receive the correct basis in their company shares, which may include basis carried over from former companies that were once part of the existing company.
Prior Rulings Allowing the Same Treatment:
200828036, 200828035, 200737046, 200615007, 200537042, 200537041, 200507016, 200340030

Disclosure: Please be sure to speak to your advisor to carefully consider the differences between your company retirement account and investment in an IRA. These factors include, but are not limited to changes to availability of funds, withdrawals, fund expenses, fees, and IRA required minimum distributions.