Pass through dividends on company stock held in 401(k) plan

OK, I researched for a long time before posting this question.  We have a client that has company stock (NYSE traded) as an investment option in their 401(k) plan.  The plan also allows participants to invest all money types, including Roth contributions, in the stock fund.  Further, the plan gives participants the option to either reinvest dividends or pass them through.  The question is if a participant invests their Roth money source in company stock and elects pass through of dividends, are the dividends taxable or tax exempt?  Thanks!

I think you think "pass them through" means that the participant can get the cash. That's not the case. It all stays in the plan.

Actually, the participant may elect to receive the cash.  Per the SPD:  “Under the Plan, dividends may be used to purchase additional (name of stock) for your account or paid out to you in cash.”

I could be wrong, I don't work on any plans that have company stock dividends paid to participants but I believe the answer to your question is: it depends. That is if the the participant is over 59 1/2 and they meet the 5 year period, then the dividend would be a non-taxable as a qualified ROTH distribution, if the participant doesn't meet both the over 59 1/2 and 5 year period, then it would be taxable just like it was not held in a ROTH account.

Is the typical 1099-R code you give on these "U" like when an ESOP pays the dividends? If yes, then if it's also Qualified ROTH I think you can use the Codes "UB"

At least that's how I see the instructions to Form 1099-R and the various codes.

Thanks so much, Lou - I appreciate your answer!  That makes perfect sense to me, although I don’t think I’ll ever see a response on point.

Joe

2 hours ago, Tegernsee said:

Actually, the participant may elect to receive the cash.  Per the SPD:  “Under the Plan, dividends may be used to purchase additional (name of stock) for your account or paid out to you in cash.”

I must admit I've never seen that in 35+ years, so I stand corrected.

Some sources of relevant Federal tax law are:

I.R.C. § 72(e)(5)(D) (“Any dividend described in section 404(k) which is received by a participant or beneficiary shall, for purposes of this subparagraph, be treated as paid under a separate contract to which clause [72(e)(5)(D)](ii)(I) [referring to a § 401(a) trust] applies.”);

I.R.C. § 72(t)(2)(A)(vi) (“dividends paid with respect to stock of a corporation which are described in section 404(k)” excepted from the additional income tax on a too-early distribution).

https://irc.bloombergtax.com/public/uscode/doc/irc/section_72

I.R.C. § 404(k) (employer’s deduction for a dividend paid out, rather than into the plan’s trust).

https://irc.bloombergtax.com/public/uscode/doc/irc/section_404

I.R.C. § 3405(e)(1)(B)(iv) (section 404(k)(2) distribution not a designated distribution).

https://irc.bloombergtax.com/public/uscode/doc/irc/section_3405

26 C.F.R. § 1.402(c)-2/Q&A-4(e) (“Dividends paid on employer securities as described in section 404(k)” not an eligible rollover distribution).

https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/section-1.402(c)-2

26 C.F.R. § 1.404(k)-1T/Q&A-3 (treating a dividend paid out, rather than into the plan’s trust, as a separate contract for I.R.C. § 72 income ordering).

https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/section-1.404(k)-1T

Interesting issue that I have never seen arise, but it looks like it's covered in Treasury Regulation 1.402A-1, Q&A 11 below. Reinvesting the dividends in employer stock that continues to be held in the participant's Roth account would allow a qualified distribution of that account balance later. 

Q-11. Can an amount described in A-4 of § 1.402(c)-2 [note: subsection (e) of this cite is 404(k) dividends] with respect to a designated Roth account be a qualified distribution?

A-11. No. An amount described in A-4 of § 1.402(c)-2 with respect to a designated Roth account cannot be a qualified distribution. Such an amount is taxable under the rules of §§ 1.72-16(b), 1.72(p)-1, A-11 through A-13, 1.402(g)-1(e)(8), 1.401(k)-2(b)(2)(vi), 1.401(m)-2(b)(2)(vi), or 1.404(k)-1T. Thus, for example, loans that are treated as deemed distributions pursuant to section 72(p), or dividends paid on employer securities as described in section 404(k) are not qualified distributions even if the deemed distributions occur or the dividends are paid after the employee attains age 59 1/2 and the 5-taxable-year period of participation defined in A-4 of this section has been satisfied. However, if a dividend is reinvested in accordance with section 404(k)(2)(A)(iii)(II), the amount of such a dividend is not precluded from being a qualified distribution if later distributed. Further, an amount is not precluded from being a qualified distribution merely because it is described in section 402(c)(4) as an amount not eligible for rollover. Thus, a hardship distribution is not precluded from being a qualified distribution.

Tegernsee, is the plan a standalone 401(k), a KSOP (combined 401(k) and ESOP), or are there two plans (a standalone 401(k) and a standalone ESOP)?  The answer to your question about the use of dividends on employer securities likely depends part on the type of plan that holds the employer securities.  There are differences in the rules applicable to employer securities held in an ESOP versus employer securities held in a 401(k). 

Bill, no problem, as I have only previously seen that in ESOPs.  This old dog learned a new trick!

Peter Gulia,  thank you for those cites - much to chew on there.

EBE Catty, I appreciate your providing that cite to Q&A 11.  It’s making my head swim.  LOL

Paul I, the plan is neither a KSOP nor a standalone ESOP, so it has none of the other ESOP-like provisions such as diversification provisions.  

If there is no ESOP, then very likely there are no dividends available to pass through to participants.  All of the references to 404(k) deal with ESOP shares.

I asked about KSOPs because some are designed to allow participants to have the pass through of dividends from the ESOP portion's dividends redirected into the 401(k) part of the plan.  They even take this one step further by allowing the dividend pass through to offset deferrals taken from payroll, but the dividends themselves are not deferrals.

My understanding is dividends on employer securities in non-ESOP accounts are not available for pass through to participants.  I double checked some ESOP, KSOP and 401(k) documents as well as the regulations and do not see anywhere that dividends on non-ESOP accounts are available for pass through.

Hopefully some of our BenefitsLink ESOP colleagues or perhaps whoever drafted the plan you are working with can let us know any explicit rules on this topic.

My experience is the same as Paul's. If you only have the SPD, I would suggest asking for the full plan document to see if the employer stock fund is considered an ESOP. 

Thanks, all.  I do have the plan document, and it has the dividend pass through provision, but the SPD was more succinct so that is what I quoted.  It is definitely not an ESOP.