This makes it two in a row for Michael J. Jones, CPA, the newest member of our LISI Commentator team.  Yesterday's release on "No-Roth 401(k) Left Behind Program should have said, "Mike Jones and Bob Keebler's No-Roth 401(k) Left Behind Program!"

Mea culpa - and with deep apologies to Mike for this oversight!

Michael J. Jones, CPA is a partner in Thompson Jones LLP, in Monterey, California and holds CPA licenses in California and Minnesota. He is a consultant in the areas of wealth transfer strategy, trust and probate matters, and family business transitions.

Mike is the author of The Pension Answer Book: Special Supplement on the Final Regulations Governing Minimum Required Distributions (Panel Publishers, June 2002). He serves on the Editorial Advisory Board of Trusts and Estates as Chair, Retirement Benefits Committee.

Please join us in welcoming Mike Jones who shares a warning with LISI members about some NUA ideas out there!

EXECUTIVE SUMMARY:

This is a warning about a highly aggressive technique that should be avoided.

FACTS:

NEW WAY TO TAKE YOUR FIRST STEP:

Beginning after 2007, Roth IRA conversions of eligible retirement plans other than IRAs need not take the intermediate step of first being transferred to an IRA.

This new rule is found in section 824 of the Pension Protection Act of 2006 ("PPA").   Among the retirement plans that fall within the definition of "eligible retirement plans" are qualified retirement plans maintained by employers.

Old Rule Example: 

Allen has a 401(k) account with his former employer.  Allen has retired, and wants to convert his account to a Roth IRA during a tax year when he satisfies all requirements for a Roth IRA conversion.

Before he makes the conversion, he must first transfer or roll over his 401(k) account to a traditional IRA.

Only after he has transferred or rolled his 401(k) account to a traditional IRA account may Allen convert the traditional IRA to a Roth IRA.

New Rule Example: 

Beginning after 2007, Allen may convert his 401(k) account directly to a Roth IRA.  Allen does not need to first transfer or roll it over to a traditional IRA.

Enter: NUA

One species of eligible retirement plan account that may be directly converted to a Roth IRA is an account that holds employer securities.   A classic example is an Employee Stock Ownership Plan, or ESOP, but other types of profit sharing accounts may also hold employer stock.

Net Unrealized Appreciation, or NUA, is just the unrealized gain on employer securities in the hands of the plan trustee as of the date distributed to the plan participant.

NUA Example.  

Beth is a participant in a retirement plan.  Over many years, the trustee of her plan account has purchased 1,000 shares of employer stock at a total cost of $40,000.

Beth retires and receives the employer stock in a qualifying lump sum distribution at a time when the stock is worth $100,000. 

Her NUA is $60,000 ($100,000 value minus $40,000 cost basis).

Special Tax Rule for NUA

Assuming Beth and the employer plan meet all of the NUA requirements:

1.     She is required to pay a current income tax ONLY on the $40,000 trustee's cost basis and not on the full $100,000 value; and

2.     Whenever she chooses to sell the NUA stock, up to $60,000 of gain is classified as capital gains, taxed at long-term rates (her income tax basis is $40,000).

3.     Any gain over that depends on her holding period, counting from the date of distribution.

Effect of Traditional IRA Rollover

If Beth rolls over or transfers her employer securities to a traditional IRA, or, alternatively, sells the NUA stock and rolls over the sales proceeds, the special tax rule for NUA is lost.

The rollover does not trigger current taxation of any part of the gain on the employer stock rolled over, whether transferred, or sold and then transferred.

However, all subsequent distributions from the IRA will be taxed at ordinary income tax rates.

Effect of Traditional IRA Rollover Followed by Roth IRA Conversion

If Beth rolls over her NUA stock to a traditional IRA, and later converts that IRA to a Roth IRA during a tax year when she satisfies all requirements for a Roth IRA conversion, she will pay income taxes at ordinary income tax rates on the full $100,000 traditional IRA amount she converts (assume no change in stock value through all of the steps).  It makes no difference that the traditional IRA received NUA-laden employer securities.

In short, Beth pays taxes on $100,000 at ordinary income tax rates to fund a $100,000 Roth IRA conversion.

Effect of Direct Roth IRA Conversion, Without Intervening Traditional IRA Rollover

Now, suppose that Beth converts her NUA-laden qualified plan account DIRECTLY to a Roth IRA during a tax year when she satisfies all requirements for a Roth IRA conversion.

As amended by PPA, section 408A(d)(3)(A) of the Roth IRA conversion rules provide that gross income includes "any amount which would be includible were it not part of a qualified [Roth IRA] rollover contribution" and without regard to the rules of section 72.

In other words, the amount to include in gross income as a result of the Roth IRA conversion is determined just as though the converted eligible retirement account had been distributed and there had been NO Roth IRA conversion.

Back to Our Example:

In Beth's case, we assumed that the NUA requirements were satisfied.  And, as already explained, in a qualifying lump sum distribution, Beth pays income taxes ONLY on the $40,000 cost basis, unless she sells the stock and keeps the proceeds – which Beth has not done.

So Beth pays income taxes at ordinary income tax rates on only $40,000 to fund a $100,000 Roth IRA conversion because:

1.     the new Roth IRA conversion rules permit direct conversion,

2.     the distribution of NUA is taxed just as though no Roth IRA conversion occurred, and

3.     there has been no sale of the employer securities.

After that, distributions from Roth IRAs are potentially tax-free, thus completely bypassing income taxation of the $60,000 NUA amount.

COMMENT:

Too Good to Be True?

Over the past few decades, we have seen some cases of aggressively marketed, so-called "abusive" tax shelters.  The lesson learned was that a pure reading of the Code that is arguable technically correct does not necessarily yield a successful tax avoidance strategy.   Such transactions have undoubtedly inspired Circular 230's section 10.35.

In converting a non-IRA retirement plan to a Roth IRA, Congress clearly and sensibly intended to dispense with one intermediate step, that step being a transitory transfer to a traditional IRA.

However, it seems highly doubtful that Congress also intended to provide a gaping opportunity to completely side-step NUA taxation.

WHAT CONGRESS NEEDS TO DO - QUICKLY!

Perhaps it would be best if Congress were to pass a technical correction to clarify its intention.  Without legislative clarification, it will be left either to the IRS or to the courts to sort this out.

And if NUA is to be taxed as part of a Roth IRA conversion, Congress should clarify whether converted NUA will be taxed in one of two possible ways:

Possibility 1:

Tax NUA at capital gains rates, as if the stock were sold and no Roth IRA conversion occurred; or,

Possibility 2:

Tax NUA at ordinary income tax rates, as if the stock were first transferred to a traditional IRA subsequently converted to a Roth IRA.

CONCLUSION:

In the meantime, practitioners should consider whether this technique should be avoided, being better viewed as highly aggressive and perhaps incapable of passing the "smell test."

HOPE THIS HELPS YOU HELP 0THERS MAKE A POSITIVE DIFFERENCE!

Mike Jones

Technical Editor - Barry Picker

CITE AS:

Steve Leimberg's Employee Benefits and Retirement Planning Newsletter # 390  (November 1, 2006) at http://www.leimbergservices.com  

Copyright 2006 Leimberg Information Services, Inc. (LISI).  Reproduction in Any Form or Forwarding to Any Person Prohibited - Except With Specific Permission!

CITES:

IRC Section 408A(d)(3)(A).  Section 402(c)(6).

P.S.

Be sure to get a copy of Barry Picker's great book, "Barry Picker's Guide to Retirement Distribution Planning".