Background:

I am a forty plus year employee of a major US Company looking at my retirement options relative to my 401K account held with this same company, but managed by a subcontracted management company. Since my first eligible contributions in Jan 1970, I have invested 100% of my investment (8% of my salary), matched at 75% (75 cents on the dollar) by my company in the “Company Stock Fund”. With the exception of a two year period (Aug 73 to Aug 75), the “Co. Matching” investments have also been 100% in the company stock fund. I’ve never switched invested dollars from this fund to any of the other 401K options (other funds). Over the years I have made one major (1977, all but “non-vested” Co. Matching), and three minor (1984, 1985, & 1986; rollovers to IRAs) withdrawals from this account.

Initially this savings plan was not a 401K per say, and my contributions were in “after tax” dollars until Jan 1983 (a portion of my 401K to this day is accounted for as such). There have been three “stock splits”, a five for four in 1973, a three for one in 1995, and a two for one in 1996. In addition, my “old” company merged with my “new” company, effective 1 Aug 1997 retaining the “new” company name and stock, with a stock conversion ratio of 1.3 : 1 (old x 1.3 = new, number of shares). During this entire time, mine and the co. matching investments in this Fund have been in “units”, not actual stock (no stock exists in my name), with each unit having a “unit value” that increases or decreases closely, but not exactly, with the current stock value. The “managing company” fees, and the fact that they keep a small portion of the total Plan value in cash rather than stock to handle transactions (people moving into and out of the “plan”) accounts for the divergence from a one to one ratio with the daily stock value. My plan value at any one time is the no. of units in my name times the current unit value. My statements list “equivalent shares” that are calculated based on my total plan value divided by the current stock value, but the actual shares owned by the entire plan (all investors included) is less than this calculation due to the amount of cash held instead of stock. In addition, both the old and new companies on a quarterly basis have paid dividends that, depending on the number of actual shares (not equivalent shares) owned by the total plan, pays dollars into the plan that are then used to purchase additional shares, then awarded to participants in the plan as additional “units” increasing that individual’s total number of units (and their number of shares of “equivalent stock”).

Issue:

I’ve recently begun researching various “tax strategies” relative to withdrawal of 401K funds/stock upon retirement, and am intrigued by the possibilities of utilizing an NUA (Net Unrealized Appreciation) approach to minimize my tax liability. As I think I understand the nuances of this strategy (convert withdrawn company stock such that they are subject to Long Term Capital Gains tax rate, not ordinary income tax rates), the method and pros/cons are not my specific question/issue. To pursue this possibility, I recently (Feb this year) asked the 401K managing company for my current “cost basis” (what I would pay ordinary income tax rates on to implement this strategy) for the entire Company Stock Fund portion of my 401K (probably would actually implement for something less than 100%, earlier “equivalent stock” would have lower “cost basis”). I was astonished when given a value roughly 38% of my current value, which seemed like a very low rate of return for an over forty year continuous investment in a very successful company (a 7.8:1 shares multiplier from 1995 to 1997 alone, and stock currently 60% of value before the 95 split). I then dusted off my old records, discovering the total of mine and the company matching contributions to the Co. Stock Fund, minus the non-appreciated portion (cost basis) of my four withdrawals, results in a number less than 15% of my current value. An investigation into the source for this difference (15% vs. 38%) discovered that they have included stock dividends in the total, calling them a “contribution”, not “appreciation” on the invested dollars.

Researching IRS Publications (550, 551) indicates that while a stock re-investment account with a broker does reduce the cost basis by the amount of the dividends earned (and reinvested), a 401K investment is significantly different. My contention is that I don’t own any actual stock in this account, but instead “units” that only as an aside are expressed in “equivalent shares”. My investment dollars are invested by the fund managers in my company’s stock, and the resulting dividends from that investment are, in my opinion, appreciation from that investment, no different than interest earned on a bond, or dividends within a mutual fund (the fund value grows independent of mine and my company’s contributions). The “units” that I own did not issue a dividend, the fund’s investment did, and the dollars from a given dividend award are not directly related to my “equivalent shares” (something less due to some of the fund kept in cash rather than stock). In addition (at least before age 59 ½), I did not have the option of receiving these dividend dollars or reinvesting them (a criteria to determine if they would be a “contribution”). If I had requested the dividend amounts be sent to me, they would have been treated as any other 401K withdrawal (ordinary income from a tax perspective), coming out of the earliest dollars invested (a “FIFO” stack), and incurring a fine for “early withdrawal”. These funds are definitely in a “Long Term” category (40+ years), and LTCG seems appropriate, with NUA seeming to provide the vehicle to pay taxes (ordinary income rates) on my invested before-tax contributions in order to convert from 401K to ordinary long term stock investment, with the hang-up being what is the correct “cost basis” (38% makes it a non-starter).

Question:

To correctly make this decision on how to utilize these 401K funds upon retirement, I need to resolve if dividends are “appreciation” or “contribution” within a 401K account. Any opinions, legal documentation/precedents (my 401K management co. will need convincing) would be appreciated!! My apologies for the wordiness.