Qualified Plan Distributions: The Net Unrealized Appreciation Exception

Take-Away: Almost all distributions from a qualified plan or IRA are taxed as ordinary income, and thus most distributions are subject to relatively high federal income tax rates, e.g. 25% or 37% rates. One exception to the ordinary income taxation of a distribution from a qualified retirement plan account is when employer stock is distributed as a lump sum to its participant- it is taxed as long-term capital gains and subject to the 20% federal capital gain tax rate. However, as always seems to be the case, the ‘devil is in the details’ when net unrealized appreciation (NUA) is to be taxed.

Background: Special income tax treatment is available for a qualified plan participant who holds employer stock held in his/her qualified plan account. The key to taking advantage of the long-term capital gain treatment for that employer stock is the timing involved when the lump-sum distribution of the employer stock is taken. If the distribution of employer stock qualifies, the net unrealized appreciation (NUA) is taxed at long-term capital gains rates, which dramatically cuts the participant’s income tax bill.

Requirements to Qualify for NUA Treatment: In order to obtain this special income tax treatment for the distributed employer stock, several conditions must be satisfied-

• Lump-sum Distribution: To qualify as a lump-sum distribution for the NUA tax treatment, the distribution must occur in one tax year; the participant’s account balance must be $0.00 at the end of the year of the distribution. As such, partial distributions will not be available for the NUA tax benefit to be achieved. If the lump-sum distribution is disqualified, the NUA tax opportunity is lost and the entire distribution, including the NUA stock, will be taxed as ordinary income.
• In-Kind Distribution: The employer stock must be distributed in-kind as stock in order to qualify for long-term capital gain treatment. The actual employer stock must be distributed to the participant in order to qualify for the special tax treatment.
• Deposit in a Taxable Account: The employer stock must be transferred to a taxable If the employer stock is rolled over by the participant to an IRA, the NUA tax savings opportunity is lost- forever.
• Other Account Assets: The non-employer stock assets held in the participant’s account can be rolled-over by the participant to an IRA as part of the lump-sum distribution that results in a zero account balance by the end of the year in which the distribution occurs.
• Tax Benefit: If the employer stock is distributed as part of a qualifying lump-sum distribution, only the cost of the employer shares when purchased in the plan is taxed at ordinary income tax rates. The appreciation in the employer stock (the NUA) is not taxed until the stock is sold. When the stock sale occurs, the gain recognized on the stock’s sale is taxed at long-term capital gains rates- not as ordinary income, which is the case with all other distributions from the qualified plan. Any appreciation in the value of the stock from the date of the in-kind lump-sum distribution to its sale is taxed as long-term capital gains, if the stock is held for at least a year before it is sold. If the employer stock is held until the former participant’s death, then there is a complete income tax basis adjustment to the employer stock to the date-of-death values eliminating any gain exposure. [IRC 1014.]

Trigger Events: The key is that there must also be a defined trigger event that occurs when the lump-sum distribution of employer stock occurs meeting all of the conditions just described. There are four separate trigger events: (i) death; (ii) attaining age 59 ½ years (if the plan document permits distributions at this ‘early’ age); (iii) separation from service (but not for self-employed individuals); and (iv) disability (but only for self-employed individuals.) Each of these trigger events is a fresh start and provides subsequent opportunity for the participant to take advantage of the NUA tax treatment.

• Example: An employee attains age 59 ½ which is one of the defined trigger events. The employee is still employed. The employee takes a partial distribution from the plan in the year that he attains age 59 ½ years. Because it is, a partial distribution the age 59 ½-trigger event is lost forever. If the employee in a later year separates from service with the employer-sponsor (a second trigger event) the NUA option is available again. If the employee takes only a partial distribution after his year of separation from employment, the second trigger event- separation from service- is lost, because it was only a partial distribution. If that is the case, the employee will have to wait until his death (the third trigger event) before his surviving spouse or designated account beneficiary can avail himself/herself of the NUA with a lump sum distribution.
• Partial Distributions: A partial plan distribution taken after a triggering event, but before the lump-sum distribution, will disqualify the lump-sum distribution for NUA purposes. Consequently, partial plan distributions such as in-service distributions under IRC 72(t) or an in-plan Roth conversion will disqualify the lump-sum distribution, at least until the next trigger event comes along.

Conclusion: Only employer stock held in the qualified retirement account qualifies for NUA tax treatment. The challenge is to make sure that the lump-sum distribution of the employer’s stock held in the account occurs on a single tax year. Probably not too many retirement accounts hold employer stock. However, given the special tax treatment that is available for the NUA held in a retiring participant’s account every effort should be made to expose that appreciation to long-term capital gain treatment and not cause it to be taxed as ordinary income.