Distributing NUA with after-tax employee contributions
Posted 20 July 2001 - 05:42 PM
A 55 year old employee retired today and must come up with $266K in cash in the next 90 days to exercise an expiring block of stock options. In place of cash, the client could conduct a "stock swap" if he owned employer shares outright (not in an IRA or 401(k)). As one might expect the client has no liquid cash or shares.
As a 55 year old, the client wanted to withdraw $300k from his Cash Balance plan (mentioned below) or 401(k) plan to avoid the 10% early withdrawal penalty - - NOT! His other sources of income for the next few years will keep him in the highest tax bracket.
However, he a Cash Balance Plan which he will probably roll to an IRA and 401(k) loaded with employer securities. The ultimate goal is to generate $266k in after-tax cash or securities prior to the upcoming stock option expiration date with the least amount of taxes - - hence, the In-Kind Distribution strategy.
$800,000 - Cash Balance Plan (not aggregated with 401(k))
$325,000 - 401(k) held as follows:
$75k in Mutual Funds - Employee Contributions
$150k in Employer Stock - Employee Contributions (NUA 120k)
$100k in Employer Stock ESOP - Employer Contributions (NUA 80k)
He has made $52k in Employee After-Tax contributions (post 86)
The plan does not specify where the $52k was invested (in funds or employer securities).
The client has a total basis of $50k in his $250k of employer securities.
Can he distribute the all of the employer securities using the after-tax portion of his plan? If so, does this mean that the client just used 50k in after-tax plan assets to distribute $250k in employer securities and did not have to report the distribution as income? Does he avoid the 10% early withdrawal on the basis of the securities? What about 20% withholding? Any ideas?
As mentioned above, this client has $150k in employer securities attributable to empolyee contributions (potentially pre-tax and post-tax) *AND* $100k in employer securities attributable to employer contributions (ESOP). With regards to a distribution of employer securities, can someone please describe the differences between distributions that:
1) Qualify as a LSD (not for forward averaging purposes)
2) Do not as a LSD
Posted 22 July 2001 - 06:40 AM
If not, then he could take a lump sum distribution from the 401(k) plan, retain employer securities with a basis equal to his after-tax contributions, and roll over the rest of the distribution to an IRA. This will preserve NUA on the retained shares and provide him with $250k of stock to help effectuate the stock-for-stock exercise.
There would be no 10% tax on the stock retained (for a number of reasons) and there will be no 20% withholding (withholding is waived if the portion of the distribution not rolled over consists solely of employer securities).
A real aggressive tax play would be to roll the retained shares into an IRA within 60 days of the date of distribution and after using the shares to exercise the option. I could not recommend this but I have seen some employees do so.
He needs to take a lump sum distribution of his entire account to get the NUA treatment. This may not be attractive if the employee likes the investment options of the employer's 401(k) plan and if the employer stock pays a dividend (no longer tax-sheltered because the shares are not in an IRA or 401(k) plan). In addition, the employee must now pay tax to diversify out of employer stock. If these issues are a concern, it might be easier to just get a short-term loan to fund the exercise.
Is the option an ISO or a non-qualified option?
Posted 22 July 2001 - 02:29 PM
You are correct the employer does not allow a “cashless exercise” – just cash and stock swaps. The total exercise cost is $266k with a total pre-tax / pre-xcost value of approximately $700,000.
YOU WROTE: >>”Is the option an ISO or a non-qualified option?”<<
Unfortunately the client is required to exercise all remaining options within 90 days - - a majority of which are ISOs (a few are non-qualified options.) In reality we can cash out the small portion of the NQs upon exercise and pay off a small short-term loan, however the client does not want a DisqDisp with the ISOs due the his 39.1% Fed. tax bracket. It appears that his regular income tax liability will still outpace his AMT this year.
YOU WROTE: >>“retain employer securities with a basis equal to his after-tax contributions, and roll over the rest of the distribution to an IRA.”<<
Ok, let me repeat this back so I am sure I understand what you said:
$325,000 LSD – (as mentioned in original post) distributed as follows:
Part 1 – Distribution = $250k of employer security share certificates (made up of securities attributable to employer and employee contributions to the plan) with a total combined Cost Basis in the plan equal to $50k should be distributed with 50k in after-tax contributions. Typically the employee would include the Cost Basis of the distributed shares as income, however, the participant has somehow convinced his plan / plan administrator to distribute all the employer securities using 50k (of his 52k) in after-tax dollars, thus reporting no income on the distributed shares.
Part2 – Distribution = $2k of after-tax cash payable to the participant (non-taxable) which represents the balance of the after-tax cash in the plan that was *NOT* used to distribute employer securities.
Part3 – Distribution = $73k of cash rolled to an IRA and payable directly to the IRA custodian FBO the participant.
Other than praying for an Act of God, how do you convince the plan / plan administrator to make such a non-traditional distribution with out “messing it up”? Any tips - other than a letter of instruction? Can a plan administrator simply refuse to allow the distribution if the plan does not specifically prohibit this type of “post-tax distribution of employer securities” transaction?
Thank you again.
Posted 23 July 2001 - 05:59 AM
It should report a total distribution of $325,000; NUA equal to $200,000; employee contributions of $52,000 (nontaxable); and a direct rollover of $73,000. This will get you where you want to be on the client's 1040 for 2001.
I've worked closely with 4 Fortune 25 companies on issues just like yours. All were familiar with the situation you described and handled things just as expected.
Again, if your client is really courageous, he might look at rolling over the distributed shares into an IRA within 60 days of distribution and after completing his stock swap. I believe this would be a DQD (since the IRS regs now say these shares are treated as ISO shares for purposes of determining DQDs) but I have seen some employees get advice to the contrary (wrong advice in my view but I am always willing to be proved wrong!). The shares might also be viewed as not the same property distributed from the 401(k) plan which disallows the rollover under section 402. Ouch! This would result in an excess IRA contribution.