in-kind distribution from 401k

[malcfp]

I have a client who is age 50 who recently separate from service from his employer. Has about $300,000 in his 401k plan of which $100,000 is company stock (all pretax). His projected income is about $24,000 annually and used standard deduction. He has given me the green light to roll the 401k to his IRA. I would like to systematically convert pre-tax dollars to Roth. However, I'm not sure if I can (or if I should) advise him to have the company stock distributed in-kind. Does anyone know what amount, if any, of the in-kind distribution would be subject to the 10% premature distribution penalty because he is under 59 1/2. Am I correct in assuming that if I were to roll the entire 401(k) (including employer stock) to an IRA, I lose the opportunity to distribute the stock in-kind and get the NUA benefits? Any other warnings/suggestions?

Thanks all.

[matt]

You really need to get up to speed on this before you advise your client and get both him, and yourself into trouble.

: I have a client who is age 50 who recently separate from service from his employer. Has about $300,000 in his 401k plan of which $100,000 is company stock (all pretax). His projected income is about $24,000 annually and used standard deduction. He has given me the green light to roll the 401k to his IRA. I would like to systematically convert pre-tax dollars to Roth. However, I'm not sure if I can (or if I should) advise him to have the company stock distributed in-kind. Does anyone know what amount, if any, of the in-kind distribution would be subject to the 10% premature distribution penalty because he is under 59 1/2. Am I correct in assuming that if I were to roll the entire 401(k) (including employer stock) to an IRA, I lose the opportunity to distribute the stock in-kind and get the NUA benefits? Any other warnings/suggestions?

: Thanks all.

[Michael E. Kitces]

: I have a client who is age 50 who recently separate from service from his employer. Has about $300,000 in his 401k plan of which $100,000 is company stock (all pretax). His projected income is about $24,000 annually and used standard deduction. He has given me the green light to roll the 401k to his IRA. I would like to systematically convert pre-tax dollars to Roth. However, I'm not sure if I can (or if I should) advise him to have the company stock distributed in-kind. Does anyone know what amount, if any, of the in-kind distribution would be subject to the 10% premature distribution penalty because he is under 59 1/2. Am I correct in assuming that if I were to roll the entire 401(k) (including employer stock) to an IRA, I lose the opportunity to distribute the stock in-kind and get the NUA benefits? Any other warnings/suggestions?

: Thanks all.

Mike,
This is a sticky area, and mistakes can permanetly result in lost opportunities, so do your research thoroughly, and consult with all necessary advisors (legal, tax, etc.), before taking ANY actions.

Now, that being said, here is the general gist on the NUA rules...

The ENTIRE account must be distributed as a LUMP SUM (I believe there are certain exceptions to this is the qualified plan is an ESOP). This will allow the unrealized net appreciation of employer stock ATTRIBUTABLE TO EMPLOYER AND NONDEDUCTIBLE EMPLOYEE CONTRIBUTIONS to be excluded from income. The basis value of the employer stock, along with all other proceeds from the distribution, is still taxed as ordinary income (and subject to early withdrawal penalties as well, if applicable). The stock can be sold at any point subsequently, and the net unrealized appreciation (NUA) is taxed as a long-term capital gain, regardless of holding period (even if you sell all the stock the day after the lump sum distribution). Any change in price from the value on the distribution date to the value on the sale date is characterized as short- or long-term, depending on the holding period from the distribution date to the sale date. At death, all NUA is treated as income in respect of a decedent (IRD) - consequently, the NUA portion of any stock appreciation does NOT receive a step-up in basis. The NUA exclusion is an OPTIONAL treatment, and anyone may 'elect out' of it - which means if you don't take it at the time, it's considered an affirmative action to decline to take the exclusion - you can't go back later and say that you forgot the first time. In addition, the NUA treatment must be elected AT DISTIRBUTION from the QUALIFIED PLAN - so if it is rolled over to an IRA, the exclusion is gone forever.

So, assuming that your client's 401(k) company stock qualifies (i.e., attributable to nondeductible employee contributions or the employer's contributions), you could take a lump sum distribution. The client would owe ordinary income tax (plus early withdrawal penalties) on the $200,000 of cash plus the amount of basis in the qualifying employer securities. The NUA of the qualifying employer securities would be excluded from income (and thus penalties as well) in the year of distribution. Thus, it appears for this client that it probably does not make sense to take the distribution at this time, even if the securities qualify. If this is a major company that your client works for, the benefits department should be able to clarify for you whether the employer stock qualifies for the NUA rules - if it is a small company, they may not, in which case you should seek the advice of a competent tax advisor instead. Under no circumstances should you assume, one way or another, whether the employer stock does or does not qualify for the NUA exclusion.

This does, however, highlight another planning item for this client - is it better to rollover to an IRA and begin Roth conversions, or leave the 401(k) IN PLACE until the client can take a lump-sum distribution without penalty, and then re-visit whether the lump-sum withdrawal is worthwhile to take the NUA exclusion. Ultimately this would depend on the client's goals, estate plans, need for liquidity and access to the funds, expected growth rate of the company stock compared to alternative investments, etc.

Also, please note as I mentioned above, that some of these rules are a little different if the employer stock is specifically in an ESOP. Either way though, I would start with the client's company's benefits department, and then consult with a competent tax advisor as well.

Best of luck!

Respectfully,
- Michael

[Lucullus]

Mike,

If you're going to work in this area, get a copy of the new edition (being released shortly) of Natalie Choate's "Life and Death Planning For Retirement Benefits". It is worth MANY times the $89 price tag.

Info is at Natalie's site: www.ataxplan.com.

A shorter treatment of this stuff, but packed with useful info, is "Barry Picker's Guide To Retirement Distribution Planning". www.BPickerCPA.com.

As Michael noted in his excellent reply, the early withdrawal penalty (72(t)) applies, but only to the amount reportable as income. Also, NUA exclusion does NOT require a Lump Sum Distribution, if any of the employer stock was purchased with EMPLOYEE contributions. "If the distribution is not an LSD, then only the NUA attributable to the employee's contribution is excludable." (Choate 2.4.02). I'd missed that myself, and noticed it only when I went to Natalie's book after reading the original posting in this thread. I surmise from the quoted passage that the excludable NUA in that situation would be calculated as the percentage of the total NUA equal to the percentage which employee contributions bears to the total cost basis.

- John Olsen

[malcfp]

Thank you all for your comments. I did alot of research prior to posting my original questions. The problem is, by the time you read various articles, and then review previous discussions on this message board, your brain gets fried. I came accross an excellent article which had alot of useful info (http://www.hr-esource.com/index.asp?rightframe=hresources/sampleChapters/ebhsampleChapter_8.html). The bottom line, for this client in question, I think I will advise him NOT to take the in-kind distributions. Instead, I think he should roll all of the pre-tax dollars to his IRA and concentrate on systematically converting a portion of the pre-tax dollars to his Roth over the next few years. Right now, his retirement assets are "overweighted" with pre-tax dollars and although he only makes about $24,000 annually, he is single and has no other deductions beside his standard deduction and personal exemption, and he's fast approaching retirement. It comes down to: where do you concentrate your tax planning efforts given the limited room to increase his taxable income now and the limited time until social security income kicks in. I think in this case, we'll get more bang for our buck by concentrating on getting dollars into his Roth where the earnings will (hopefully) be taxed at a 0% rate rather than a capital gains rate. Make sense? Thanks again for your help.

[Michael E. Kitces]

: Mike,

: If you're going to work in this area, get a copy of the new edition (being released shortly) of Natalie Choate's "Life and Death Planning For Retirement Benefits". It is worth MANY times the $89 price tag.

: Info is at Natalie's site: www.ataxplan.com.

: A shorter treatment of this stuff, but packed with useful info, is "Barry Picker's Guide To Retirement Distribution Planning". www.BPickerCPA.com.

: As Michael noted in his excellent reply, the early withdrawal penalty (72(t)) applies, but only to the amount reportable as income. Also, NUA exclusion does NOT require a Lump Sum Distribution, if any of the employer stock was purchased with EMPLOYEE contributions. "If the distribution is not an LSD, then only the NUA attributable to the employee's contribution is excludable." (Choate 2.4.02). I'd missed that myself, and noticed it only when I went to Natalie's book after reading the original posting in this thread. I surmise from the quoted passage that the excludable NUA in that situation would be calculated as the percentage of the total NUA equal to the percentage which employee contributions bears to the total cost basis.

: - John Olsen
:

John,
If the distribution is not an LSD, then only the NUA attributable to the employee's NONDEDUCTIBLE contribution is excludable. Per the original section in the IRC...

IRC, 2002-CODE-VOL, SEC. 402. TAXABILITY OF BENEFICIARY OF EMPLOYEES

[Michael E. Kitces]

: Thank you all for your comments. I did alot of research prior to posting my original questions. The problem is, by the time you read various articles, and then review previous discussions on this message board, your brain gets fried. I came accross an excellent article which had alot of useful info (http://www.hr-esource.com/index.asp?rightframe=hresources/sampleChapters/ebhsampleChapter_8.html). The bottom line, for this client in question, I think I will advise him NOT to take the in-kind distributions. Instead, I think he should roll all of the pre-tax dollars to his IRA and concentrate on systematically converting a portion of the pre-tax dollars to his Roth over the next few years. Right now, his retirement assets are "overweighted" with pre-tax dollars and although he only makes about $24,000 annually, he is single and has no other deductions beside his standard deduction and personal exemption, and he's fast approaching retirement. It comes down to: where do you concentrate your tax planning efforts given the limited room to increase his taxable income now and the limited time until social security income kicks in. I think in this case, we'll get more bang for our buck by concentrating on getting dollars into his Roth where the earnings will (hopefully) be taxed at a 0% rate rather than a capital gains rate. Make sense? Thanks again for your help.

Mike,
It sounds like you've got a reasonable course of action laid out. However, a few caveats...

Be sure that the client will not need the money before age 59 1/2. If you begin converting to a Roth IRA, then per the conversion rules the Roth assets will not be accessible for the next 5 years without a 10% penalty. Moreover, you wouldn't want to take any 72(t) substantially-equal-periodic-payments (SEPPs) from the Roth IRA (because the SEPP rules avoid the premature-tax-penalty, but they do NOT allow tax-free withdrawals from the Roth). You could still do SEPPs on the unconverted rollover IRA balance, but if too much has been converted, the asset base in the regular IRA may be too low to create sufficient withdrawal amounts for the client.

In addition, if the client may need to substantially draw on the assets before 59 1/2, it may be better to leave the assets in the 401(k), so that the client can take a lump sum distribution penalty-free at age 55 from the qualified plan (if also allowed under the plan document). And if/when taken as a lump sum distribution, there might also be NUA opportunities, if all other requirements are met. The primary purpose of leaving assets in the 401(k) for lump-sum withdrawal don't have to be purely from a NUA or tax perspective - if he is going to need access to the funds, he can get at the entire amount of them penalty-free a little sooner if they stay in the 401(k).

Just a few other considerations to bear in mind. Hope everything works out well for you and your client.

Respectfully,
- Michael

[Lucullus]

Michael,

You one smart cookie, you betcha.

- John