By Denise Appleby, CISP, CRC, CRSP, CRPS, APA
To understand the significance of this guidance, we need consider the tax treatment of NUA eligible stocks and amounts eligible for income averaging that are distributed from a qualified plan.
Tax Treatment of Distributions of NUA Stock and Income-Averaging Eligible Amount
If an individual owns NUA eligible employer stocks in his qualified plan account, or has a distribution that is eligible for ten-year forward averaging, the tax treatment of the distribution is generally determined by whether the stock is rolled over to an IRA or other eligible retirement plan, or distributed to the individual. The tax results are as follows:
- Distributed to the individual[ii]: If the stock is distributed to the individual, the basis is included in his income at his marginal tax rate for the year the distribution occurs, and the NUA would be included in his income at capital gains rate when he sells the stock. If he is under age 59 ½ when the distribution occurs, the basis is subject to a 10% early distribution penalty, unless an exception applies.
- Rolled over: If the stock is rolled over to a non-Roth IRA[iii] or other eligible retirement plan, the rollover is a nontaxable transaction. Any subsequent distribution of the stock, including the amount representing the NUA or proceeds from liquidation of the stock, is included in income at the individual’s marginal tax rate for the year the distribution occurs.
Income Averaging Eligible Amounts
- Distributed to the individual: If the amount is distributed to the individual, he has the option of electing the income averaging tax treatment. Under this option, the amount is included in income for the year the distribution occurs, but federal income tax is assessed as if the distribution was taken over a ten year period- which often results in a reduction in the amount of tax owed.
- Rolled over: If the stock is rolled over to a non-Roth IRA[iv] or other eligible retirement plan, the rollover is a nontaxable transaction. Any subsequent distribution of the amount is included in income at the individual’s marginal tax rate for the year the distribution occurs.
Distributions from Employer Plans before January 1, 2008
Distributions from employer plans that occurred before January 1 2008 were allowed to be converted to a Roth IRA only if the amount was first rolled over to a traditional IRA. The rollover from the employer plan to the traditional IRA is a reportable but nontaxable transaction, which means that any taxes owed on the amount would continue to be deferred. The conversion from the traditional IRA to the Roth IRA is required to be included in the Roth IRA owner’s income for the year that the funds are distributed from the traditional IRA. Any federal tax owed is assessed at the individual’s marginal income tax rate, including any employer stocks and NUA amounts that were rolled over to the traditional IRA. As a result, if the individual rolled over NUA eligible stocks to the traditional IRA, the opportunity to apply capital gains treatment to the NUA portion is lost.
Distributions from Employer Plans January 1, 2008 and After
For distributions from employer plans that occurred January 1, 2008 and after, the amounts could be rolled over directly to a Roth IRA. Amounts rolled over from employer plans to Roth IRAs are included in the owner’s income for the year the amount is distributed from the employer plan.
The Unclear Issue
Considering that when the individual took the basis in income, including the income from the NUA was deferred until the stock is sold, it was unclear as to whether this same treatment would be available for rollover to Roth IRAs- since such rollovers also resulted in the basis being included in income. If that was the case- the question then becomes “How is the NUA portion treated in the Roth?”[v] The application of the capital gains treatment to the NUA amount in a Roth IRA presented a dilemma from three angles:
If the stock is sold in the Roth IRA, the sell transaction is not reported to the IRS. This is unlike a sale of stock outside of a retirement account which is reported to the IRS, thus alerting the IRS that the owner should report a capital gains or loss on his tax return. If the sell is not reported to the IRS, then they would not be aware that the capital gains treatment needed to apply.
When the NUA election is made, any earnings that accrue on the stock after the date of the distribution from the employer plan, is taxed at long term or short term capital gains rate, depending on how long the stock is held outside of the retirement plan. However, earnings in retirement accounts are taxed at the individual’s marginal tax rate, unless the amount is eligible for tax-free treatment
Distributions from Roth IRAs can be tax-free if they are qualified. Therefore, if the distribution is qualified, it could mean that the NUA amount is distributed tax-free, thus avoiding the tax that is owed on the NUA amount.
Another possible issue is whether the income averaging treatment could be applied to the amount if it was rolled over to a Roth IRA.
Considering these issues, the solution would require a modification of the Roth distribution rules to ensure that the individual could avoid the tax due on the amount, or applying the tax treatment that applies to amounts that are not rolled over. According to Notice 2009-75, the latter applies.
The Right Tax-Treatment…According to the IRS…
According to Notice 2009-75, taxable amounts rolled over from retirement plans to Roth IRAs are subject to the same tax-treatment that would apply, had the amount been rolled over to a traditional IRA and subsequently converted to a Roth IRA. In short, the rollover will result in any taxable amount being included in the income of the individual, and taxed at his marginal tax rate. The NUA and income averaging tax treatment would not be available to these amounts.
Individuals who are considering rolling over employer stocks with NUA, and amounts eligible for income averaging should consult with their financial or tax professional to compare the possible net difference in income tax for the Roth rollover vs electing to apply these special tax treatments by not rolling over the amount to their Roth IRAs. They should also determine if the benefits of the Roth IRA could outweigh the benefits of these tax treatments.
 For this purpose, employer plans are qualified plan, 403(a) annuity plan, 403(b) plan, or an eligible governmental 457(b) plan
[i]The NUA and forward averaging treatment are available only for lump-sum distributions
[ii] The stock must be part of a lump-sum distribution in order to be eligible for the NUA tax treatment
[iii] Does not include SIMPLE IRAs, as distributions from non-SIMPLE IRA retirement accounts cannot be rolled over to a SIMPLE IRA.
[iv] Does not include SIMPLE IRAs, as distributions from non-SIMPLE IRA retirement accounts cannot be rolled over to a SIMPLE IRA.
[v] Each time we received this question, it lead back to an article written by Mike Jones, CPA– making it clear that he was the one who discovered the need for clarification from the IRS.