401(k) Conversion to Roth – best way in order to take advantage of NUA for Stock held in the account

Submitted by Ryan Bruce on Mon, 2019-11-04 16:25

I have a client with a large 401(k), approx $2.02M. Roughly $600K of the value is in various stock issues held in the account. A two part question: a.) What is the best method to convert this account to a Roth? (conversion will allow 10 yr investment window based on 70.5 age of traditional RMD withdrawal); b.) can the NUA be used to save some taxes on the gain of the stock held inside the 401(k)?



Submitted by Alan - IRA critic on Mon, 2019-11-04 17:49

  • Generally, a plan that includes NUA and conversions should be designed to keep the marginal rate in current and future years about even. In this case, SS retirement benefits should also be deferred to age 70 to provide more space to convert until then. If client is not totally retired or has other income such as rental properties, or perhaps expects a significant inheritance or a change in marital status, all these factors must be incorporated into the plan. As for employer shares, diversification always trumps tax benefits, but you indicated “various” stock issues. Are all these issues employer shares eligible for NUA with a qualified LSD, and if so are they different holdings with different % of cost basis?  Typically, NUA is most beneficial if the cost basis does not exceed 25% of the FMV, and a plan that includes NUA can certainly use just some of the shares for NUA and rollover and sell the rest to address diversification needs without a current tax impact of owing tax on the cost basis and cap gains on the NUA soon after the LSD. Finally, if there is a balance of after tax (non Roth) contributions in the plan, it needs to be determined if the plan will use that balance to reduce the cost basis of NUA shares, or will allow client to assign the after tax amount separately allowing a non taxable Roth rollover of the after tax contributions. 
  • Note that dollars converted reduces future RMDs, but rarely would it be beneficial in typical asset profiles of clients to convert the entire pre tax balance. It is likely that converting half will reduce the marginal rate caused by RMDs to a point where additional conversions might be at a higher rate than the RMDs. That is not advisable. At 65, IRMAA surcharges must also be considered and added to the tax on conversions as well. A conversion plan would therefore be designed to limit MAGI for IRMAA purposes from passing into the next higher tier.
  • Therefore, there are multiple variables to be considered, and any conversion plan may have to be revisited often since circumstances will change. Major market losses or gains can also change projected tax rates as can future tax legislation sometimes driven by which political party is in power. Currently, it is not possible to predict if current rates will actually sunset in 2025 or will change before then or be extended for the applicable tax bracket of the client.


Submitted by Ryan Bruce on Mon, 2019-11-04 22:55

Thank you Alan.The stock issues are mostly my clients company stock issued at various dates. Yes, each issue has a separate basis. My client’s pension and Social Security (including his wife’s) will already put him right at/over the $170K first IRMAA tier. He will be taking SS as soon as eligible for ‘full’ retirement as we need to keep his taxable income as low as possible. He also has several stock option issues that start to come due in the next couple years that ‘could’ generate taxable income – though cap gains. In the end, a full conversion to eliminate any additional taxable income is in the clients best interest. NPV calculations based on federal taxes paid on RMD’s taken on the 401(k) at 2017 tax rates (our only known for post 2025) for 25 years vs paying the tax on the conversion now are very favorable to my client for converting now. Not knowing how future IRMAA brackets will treat income (meaning it’s likely that income levels may be reduced to include more people in the entitlement payments) AND protecting my clients wife from potentially vaulting into the highest IRMAA brackets if her husband predeceases her, also make the need to create after tax income viable.Thus, can NUA be utilized for the stock held in his 401(k) when converting the entire account to a Roth? Do we need to roll the 401(k) to a ‘temporary IRA’ first. The do a Roth conversion in two parts: a.) cash from the 401(k), then b.) sell the stock issues and move the proceeds to the Roth, paying cap gains on the growth and income tax on the basis? 



Submitted by Alan - IRA critic on Tue, 2019-11-05 00:39

  • A unitized stock fund is eligible for NUA. The # of units the participant wants to use for NUA must be converted to shares and distributed to the participant. Most plans report these shares on an average cost basis, notwithstanding that all purchases were made at different prices over the years. If the plan will provide written documentation showing lots of shares purchased at different prices, then it would be very risky to attempt to use any basis other than average cost for all the shares distributed. Client must also be sure they have a triggering event after which no intervening distributions have been taken between the date of the triggering event and the year of the LSD or the LSD will not qualify for NUA. Client should get a cost basis quote on the NUA shares, and that is the time to also find out if the plan provides a breakout of different purchase lots.
  • If eligible for NUA and shares are distributed to a taxable brokerage account, that reduces the balance in the plan that can be converted.  NUA cannot be utilized on shares and then the proceeds rolled over to any kind of IRA, although it is possible to receive a distribution of shares, then within 60 days roll over shares that will not be used for NUA due to the cost basis being too high or any other reason.  
  • A Roth rollover can be done directly from the plan to a Roth IRA OR the plan balance can be rolled over to an IRA and then incremental Roth conversions done for amounts that make sense for the current tax year. Either will work, but note that ANY employer shares once rolled into an IRA forfeit any future NUA application to those shares. Your last question appears to address this. Typically, the shares to be utilized for NUA are distributed at the same time direct rollover to either TIRA or Roth IRAs are done with the amounts still in the plan after the NUA shares were distributed. ALL plans of similar type must be fully distributed or again it will not be a qualified LSD. For example, an ESOP plan is a similar type to a 401k, but a defined benefit plan is not.
  • IRMAA tiers resume COLA adjustments in 2020 and beyond. But Congress has changed the tier structure a couple times already and more changes are very possible including more tiers at different surcharge %s. 
  • I am not clear on what client’s age is, but originally guessed it was 60 based on the 10 year conversion window to 70.5. That might not be correct. If client is under 59.5, the 10% penalty on the cost basis might apply to distributed shares, although the age 55 separation exception would also work to waive the penalty. Also, not clear if client will be trying to squeeze the LSD in this year or was planning it for a later year. Getting a little late for this year including adequate planning time.


Submitted by Ryan Bruce on Wed, 2019-11-06 18:21

Alan, The Client in question is currently 61. Presuming we can do the rollover: some this year, balance Jan/Feb next year to spread the tax liability); we will have 10 years of investment horizon to grow the Roth. He has 9 different stock/fund issues inside the 401(k). He has details of cost basis, units, and current value (based on his last update). Rough distribution: $1.6M cash (investments), $586K stock/fund value ($202K basis). The goal is to convert the entire value of the acccount $2.18M to a Roth and can’t find clear documentation on how to use NUA to reduce the tax liability for the stock/fund held. The 401(k) is currently dormant – meaning there are no further contributions being made. Thus, his qualifying event is that he is 59.5.  Thank you.



Submitted by Alan - IRA critic on Wed, 2019-11-06 20:15

  • How can he have 9 different stock holdings eligible for NUA?  Mergers and spinoffs involving his employer can result in some additional company shares, but 9 is unlikely. Even if all these shares were eligible for NUA, if the average share is cost basis is nearly 35% of the FMV, that is quite high to benefit from NUA. Perhaps certain shares have a much lower % cost basis, in which case he might distribute them for NUA and sell or roll over the others to an IRA.  All the shares do not have to be distributed for NUA purposes. Whichever shares client chooses to distribute, he will owe taxes at the ordinary income rate on the cost basis in the LSD year. The NUA per share is not taxed until he sells them in the taxable account. For that sale he is taxed at the LTCG rate on the amount of NUA per share and also pays that rate on additional gains after distribution except that the additional gains are taxed at the ST rate if sold within one year from distribution. The savings is the difference between the LTCG rate (which could be as high as 23.8% if his taxable income is high enough to trigger the 20% rate plus 3.8% NIIT if that threshold is exceeded. However, offsetting the savings is loss of tax deferral on the cost basis amount, which is due for the LSD year. Again, any shares distributed for NUA purposes cannot be sold at the NUA rate, and the proceeds rolled into any type of IRA. Client either uses NUA or rolls the shares over to an IRA, so if he distributes 586k worth of company shares for NUA, the most that can be rolled over to a Roth or TIRA is 1.6mm.
  • The LSD that includes any NUA shares must result in no assets left in the plan or similar plans of the same employer at the end of that year. He also cannot have taken any distributions before the LSD year and the date he reached 59.5, since those would be intervening distributions that disqualify the LSD for NUA.
  • The most simple way to reach these goals is to complete the LSD including a distribution of the stock shares for NUA and the rollover of the rest to a TIRA. He can then convert the TIRA incrementally until the year he reaches 70.5 so as not to spike his tax bracket. Of course, if he converts 175k-200k every year until 70.5 that alone will probably expose his taxable income to at least one higher bracket. IRMAA would be triggered at age 65 by his age 63 MAGI.
  • See this article on NUA:  https://www.kitces.com/blog/net-unrealized-appreciation-irs-rules-nua-from-401k-and-esop-plans/


Submitted by fairira on Thu, 2019-11-07 01:49

Alan, you said above: “The LSD that includes any NUA shares must result in no assets left in the plan or similar plans of the same employer at the end of that year. He also cannot have taken any distributions before the LSD year and the date he reached 59.5, since those would be intervening distributions that disqualify the LSD for NUA.”     Did you mean to say ” . . . before the LSD year and the date he reaches 59.5 . . . ” or ” . . . between the LSD year and the date he reaches 59.5 . . .”?



Submitted by Alan - IRA critic on Thu, 2019-11-07 04:02

  • You are correct. Should have been “BETWEEN the LSD year and the date he reached 59.5”.
  • For others concerned about intervening distributions in general, it could be stated that an intervening distribution is one that occurs after the latest triggering event and prior to the LSD year. A retiree could take partial distributions from the plan that are intervening distributions for the retiree personally, but if the retiree leaves the NUA shares in the plan and then passes, his beneficiary can utilize NUA because the death of the participant became a new triggering event.


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