401(k) Net Unrealized Appreciation (NUA) Rules And Caveats

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Transfer or Rollover Options

You may be able to defer tax on all or part of a lump-sum distribution by requesting the payer to directly roll over the taxable portion into an individual retirement arrangement (IRA) or to an eligible retirement plan. You may also be able to defer tax on a distribution paid to you by rolling over the taxable amount to an IRA within 60 days after receipt of the distribution. If you do a rollover, the regular IRA distribution rules will apply to any later distributions, and you can’t use the special tax treatment rules for lump-sums (described earlier). For more information on rollovers, refer to Topic No. 413 and visit Do I Need to Report the Transfer or Rollover of an IRA or Retirement Plan on My Tax Return?

Lump-Sum Treatment Options

You can elect to treat the portion of a lump-sum distribution that’s attributable to your active participation in the plan using one of five options:

  1. Report the taxable part of the distribution from participation before 1974 as a capital gain (if you qualify) and the taxable part of the distribution from participation after 1973 as ordinary income.
  2. Report the taxable part of the distribution from participation before 1974 as a capital gain (if you qualify) and use the 10-year tax option to figure the tax on the part from participation after 1973 (if you qualify).
  3. Use the 10-year tax option to figure the tax on the total taxable amount (if you qualify).
  4. Roll over all or part of the distribution. No tax is currently due on the part rolled over. Report any part not rolled over as ordinary income.
  5. Report the entire taxable part as ordinary income.

Who benefits?

Clients might be interested in the NUA strategy if they:

  • Have separated from the service of an employer (or are otherwise eligible to take a lump-sum distribution of their account).
  • Own highly appreciated employer stock in an employer-sponsored retirement plan.
  • Expect to be in a high tax bracket when they sell the company stock for income.

G. Tax on Prior Year Lump-Sum Distributions

In some circumstances, the federal rules for multiple lump-sum distributions do not apply for California. Under California law, if you received a lump-sum distribution before 1987 and you received a lump-sum distribution in 2018 that is the only lump-sum distribution you received after 1986, figure your tax on the lump-sum distribution for 2018 separately on Schedule G‑1. Do not include the lump-sum distribution you received before 1987 on Schedule G‑1.

Gross Non-Employee Compensation

Taxable gross compensation is not limited to employee compensation. It also includes:

Executor or Administrator Fees

Executor fees are taxable as compensation. This includes executor’s fees paid to nonresident executors and administrators for estates in Pennsylvania. It is presumed that these fees are received for services performed in Pennsylvania by the executor and/or his or her agent (such as an attorney) and the burden of proof falls upon the taxpayer to prove otherwise. Any apportionment must be reported on PA-40 Schedule NRH, Apportioning Income by Nonresident Individuals.

An executor or executrix for an estate in Pennsylvania would be required to visit Pennsylvania to complete his or her duties. The fact that the executor or executrix may use an agent to do the duties does not take away the fact that they had a presence in Pennsylvania and are subject to tax on that income. The only apportionment to be done is to exclude that portion of the executor fee that represents the services performed outside of Pennsylvania for the convenience of the estate and by necessity out of Pennsylvania. An example would be an appearance in court outside of Pennsylvania involving the estate. The remainder of the fee would be taxable as compensation for Pennsylvania purposes by nonresident executors. Apportionment can only be done by the number of days required out of Pennsylvania over total days spent working on the estate, including the time of the agent. The executor or executrix may be able to get some credit on another state’s return for the income taxed by both states

Expert Witness Fees

Expert witness fees are taxable compensation for Pennsylvania personal income tax purposes.

Jury Fees

Fees received for participation as a jurist in a civil or criminal trial proceeding or for a grand jury are taxable compensation for Pennsylvania personal income tax purposes.

Director Fees

Director fees are taxable compensation for Pennsylvania personal income tax purposes. If expenses are incurred while performing the duties as a director, those expenses that are directly related to that compensation may be claimed on PA-40 Schedule UE, Allowable Employee Business Expenses.

Important: Director’s fees must often times be reclassified from business income to compensation for Pennsylvania personal income tax purposes. Only individuals who clearly hold themselves out in the market place as a board director to multiple organizations and corporations may report the income and expenses on PA Schedule C, Profit or Loss from Business or Profession.

Foster Care Provider Payments

For taxable years beginning on or after Jan. 1, 1995, remuneration received by a foster care provider for in-home care of foster children received from an agency of the commonwealth or political subdivision or an organization exempt from federal income tax under IRC Section 501(c)(3) are not compensation subject to Pennsylvania personal income tax, unless the taxpayer is in the business of providing foster care.

Other Miscellaneous Compensation

Miscellaneous Compensation also includes nonemployee compensation from sources other than a federal Form W–2 or 1099-MISC. It may include:

  • Covenant not–to–compete;
  • Damages or settlement for lost wages other than personal injury;
  • Early distribution from retirement or pension plan;
  • Television Game Show or “Reality” Show winnings;
  • Medicare waiver (difficulty of care) payments;
  • Whistleblower payments; or
  • Other nonemployee compensation (description required).

Federal Form 1099–MISC Income

Fees, commissions, rewards, golden parachute payments, damage awards, termination payments, fringe benefits or other items of non-employee compensation reported on federal Form 1099–MISC are taxable as compensation.

Pennsylvania Personal Income Tax Treatment of Household Employees

A household employee, who can include babysitters, caretakers, nannies, health aides, private nurses, housekeepers, cleaning people, drivers, and yard workers, is a person hired to do any sort of household work as long as the employer retains the right to control the details of how the work is done. This differs from house workers obtained through an agency or self-employed workers who retain control of how the work is done. Generally, a self-employed worker provides his or her own tools and offers services to the public as an independent business. These individuals must file and report their income through the appropriate business schedule.

Since household employees are not subject to federal income tax withholding (although they may be subject to Social Security withholding), they are not subject to Pennsylvania income tax withholding.

D. How Often You Can Choose

After 1986, use Schedule G‑1 only once for each plan participant. If you receive more than one lump‑sum distribution for the same plan participant in one tax year, treat all of the distributions in the same way. Combine the distributions on a single Schedule G-1.

If you make an election as a beneficiary of a deceased participant, it does not affect any election you can make for qualified lump-sum distributions from your own plan. You can also make a separate election as the beneficiary of more than one qualifying person.

Example: Your mother and father died and each was born before January 2, 1936. Each participated in a qualified plan of which you are the beneficiary. You also received a qualified lump-sum distribution from your own plan and you were born before January 2, 1936. You may make a separate election for each of the distributions; one for yourself, one as your mother’s beneficiary, and one as your father’s beneficiary. It does not matter if the distributions all occur in the same year or in different years. File a separate Schedule G-1 for each participant’s distribution.

Pennsylvania Compensation – General Rules

Pennsylvania Statutes, Regulations and Other Guidance

The sections of the Tax Reform Code of 1971 relating to compensation can be found at 72 P.S. §§ 7301(d), 7303(a)(1). The department has issued regulations to interpret the definition of compensation and its exclusions. The regulations relating to compensation can be found at 61 Pa. Code § 101.6. The department also issues guidance in the form of tax bulletins, letter rulings, and other materials with can be found on the department’s website.

W–2 Wage and Tax Statement (PA-40 Schedule W2–S, Wage Statement Summary)

A W-2 Wage and Tax Statement (federal Form W-2) and/or PA-40 Schedule W2–S, Wage Statement Summary, must be submitted with the PA–40 Individual Income Tax Return, as evidence of compensation paid and taxes withheld by an employer. When submitting federal Form W–2, the taxpayer must submit a separate form for each employer.

If submitting PA-40 Schedule W2–S, Wage Statement Summary, the taxpayer copies the information from each federal Form W-2 over to the PA-40 Schedule W2–S. Refer to the Instructions for PA-40 Schedule W-2S, available on the department’s website, for detailed guidance on completing the PA-40 Schedule W2-S or when to include federal Form W-2.

Use Part B of PA-40 Schedule W2–S, Wage Statement Summary, to list all the sources of non-employee and other compensation. Report Pennsylvania-taxable compensation and any Pennsylvania tax withheld from that income. Include Pennsylvania-taxable amounts from federal Form 1099 that show pensions, retirement plan distributions, executor fees, jury duty pay and other miscellaneous compensation.

Withholding Requirements

Under the Tax Reform Code of 1971, every “employer” who has an office or transacts business within Pennsylvania must deduct and withhold Pennsylvania personal income tax from all wages paid to its resident employees, regardless if the services are performed inside the state or outside. The same is required for all wages paid to nonresidents for services rendered inside Pennsylvania unless the employee is a resident of a reciprocal state. 72 P.S. §7316.

Refer to PA Personal Income Tax Guide – Income Subject to Withholding, Estimated Payments, Penalties, Interest and Other Additions for detailed guidance regading withholding requirements.

Reciprocal Compensation Agreements

Pennsylvania currently has reciprocal agreements with Indiana, Maryland, New Jersey, Ohio, Virginia, and West Virginia. See note:  Ohio Reciprocal Compensation Agreement.

Under these agreements, one state will not tax a resident of the other state on compensation that is subject to employer withholding. These agreements apply to employee compensation only. They do not apply to income reported as compensation when there is no federal withholding requirement, such as executor fees or director fees, nor does it apply to any other class of income.

Residents of these states may file an REV-419, Employee’s Nonwithholding Application Certificate, if your employer agrees to withhold and remit your resident state’s income tax so your employer can discontinue withholding Pennsylvania personal income tax from your pay. Complete a new REV-419 every year or when your personal or financial situation changes. Photocopies of this form are acceptable.

If you are a Pennsylvania resident working in one of these states and your employer withheld the other state’s income tax, you must file for a refund from that state. File early so you will have your refund before the due date for paying your Pennsylvania tax liability.

If you are a resident of a reciprocal agreement state working or performing services in Pennsylvania and your employer withheld Pennsylvania income tax, you may request a refund of the Pennsylvania tax. You report zero taxable compensation on Line 1a and the Pennsylvania tax withheld on Line 13. Submit federal Form W–2 or a photocopy and a copy of the resident income tax return that you filed/will file with your resident state. Also, submit a statement explaining that you are a resident of a reciprocal agreement state.

Note: Ohio Reciprocal Compensation Agreement: Commencing Jan. 1, 2004, remuneration paid to a Pennsylvania resident twenty percent shareholder-employee of an Ohio S corporation for services performed in Ohio is not covered by the Pennsylvania/Ohio Reciprocal Compensation Agreement and is subject to tax in Ohio. Likewise, remuneration paid to an Ohio resident twenty percent shareholder –employee of a Pennsylvania S corporation for services performed in Pennsylvania is not covered by the Pennsylvania/Ohio Reciprocal Compensation Agreement and is subject to tax in Pennsylvania.

Federal/Pennsylvania Personal Income Tax Differences in Arriving at Box 16 Wages

Under Act 2005-40, the federal constructive receipt rules relating to nonqualified deferred compensation plans and unfunded section 457 deferred compensation plans were made applicable for personal income tax purposes. If you receive distributions of previously taxed elective deferrals, complete and include with your return the PA-40 W-2 RW, Reconciliation Worksheet. Refer to PA Personal Income Tax Guide – Income Subject to Withholding, Estimated Payments, Penalties, Interest and Other Additions.

Heres an example of how it works

Let's say you work for a publicly traded company that has a stock-option purchase plan allowing you to purchase shares of the company for a discount. You purchase 1,000 shares at $10 a share ($10,000) and it sits inside your 401(k).

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Let's say that the stock is worth $100,000 when you get ready to retire. If you roll that account over to an IRA, that money is going to be 100% taxable at your ordinary income tax rate when it comes out. However, if you use the NUA strategy, you get a significant tax break. You can transfer all those shares to a non-qualified brokerage account — non­IRA, non 401(k) — and the only tax liability you will have is ordinary income tax on the $10,000, which is the cost basis of that stock you originally purchased. If you're younger than 59½, you'll pay an extra 10% penalty on the $10,000 cost basis.

1099-R distribution codes

The 1099-R includes a form field where a code is used identify the type of distribution. This is indexed on Box 7.

  • Code 1: Early distribution, no known exception
  • Code 2: Early distribution, exception applies
  • Code 3: Disability
  • Code 4: Death
  • Code 7: Normal distribution
  • Code 8: Corrective refunds taxable in current year
  • Code G: Direct Rollover to a qualified plan, 403(b), governmental 457(b) or IRA
  • Code L: Loan treated as a distribution
  • Code M: Qualified Plan loan offset

Regarding 1099-R distribution codes, retirement account distributions on Form 1099-R, Code 4 are taxable based on the amounts in Box 2a.

Include the federal withholding amount reported in Box 4 as an additional withholding.

Follow these Steps for aSuccessful NUA Transaction

Before exercising a distri­b­ution or rollover, follow these five steps designed to help you under­stand what it takes to complete a successful NUA transaction.

  1. Start early—the NUA trans­action may take several weeks. Be sure to obtain a written copy of your cost basis from the plan sponsor before initi­ating the rollover. You should also request formal documen­tation showing your employer’s promise to make an in-kind distri­b­ution of the company shares.
  2. Determine the amount of gain in the stock price. In an employer-sponsored retirement plan, you can elect an NUA on some, all, or none of the shares. As a rule-of-thumb, you only want to use this strategy on shares currently selling for twice your cost basis.
  3. Select the sequence of trans­ac­tions when the plan holds other assets in addition to employer securities. You can transfer the company stock portion (which still qualifies for the tax break on the NUA) to a taxable (non-IRA) investment account, and you can roll the non-company stock portion of the plan into an IRA rollover account. You should execute the IRA rollover first for all assets except the company stock, then the NUA shares can be distributed in-kind, with nothing to withhold for the IRS from either trans­action. Note that unless it’s a trustee-to-trustee transfer, or the only remaining asset being distributed is employer stock, your employer is required to withhold 20% of distri­b­u­tions for taxes.
  4. Know Your Liabil­ities. You should have your tax profes­sional prepare a tax projection to determine the amount needed, and be prepared to pay the IRS in April.
  5. Prepare an exit strategy. Assuming you’re optimistic about your company’s future and proceed with the in-kind distri­b­ution, you should still have an exit strategy if the stock starts to decline. One possi­bility would be to give some or all of the stock to a chari­table remainder trust (CRT). Once the stock is trans­ferred to a CRT, the shares can be sold by the trustee and reinvested in a diver­sified portfolio that can provide lifelong income to the donor. The chari­table deduction might even offset most of the tax oblig­ation on the cost basis.

An NUA distri­b­ution may not be a good idea if the company’s outlook is bleak. The tax benefits are wasted if the company stock declines signif­i­cantly after the distri­b­ution. An investor with 98% of their retirement account tied up in one stock may want to consider selling a portion of the stock position with the highest cost. Use the NUA strategy to distribute a smaller portion of the stock in-kind. Second, never attempt to complete an NUA distri­b­ution late in the year. It’s better to wait until the beginning of the next year, because the entire distri­b­ution (rollover and in-kind distri­b­ution) must be completed in the same calendar year.

Our team of advisers guides our clients through tax strategies to help them take advantage of oppor­tu­nities and avoid mistakes. We believe retirement planning is more than just picking invest­ments. You should have a partner to guide you through today and lead you to tomorrow.

Requirements for Net Unrealized Appreciation

To qualify for the favorable tax rules of the NUA strategy, you must:

  • Have employer securities in a qualified employer-based retirement account. These include company stock in a profit-sharing plan, stock bonus plan, or pension plan that your employer bought or you paid for with pretax dollars.
  • Take a lump-sum distribution from a retirement account as a result of leaving your job or reaching age 59 1/2. A lump sum is a one-time distribution in one year of the entire balance of all qualified retirement accounts of a certain kind. Profit-sharing plans are one type of these plans. This can also apply if you're the beneficiary of a plan of someone who dies.
  • Take a direct contribution of stock from the plan. In other words, don't roll over the stock to an IRA first and liquidate it. Move it directly into a taxable account.

NUA tax treatment benefits and considerations comparison

Benefits Considerations
Direct rollover5 to an IRA — NUA tax treatment no longer available
  1. Income taxes and the potential 10% early withdrawal penalty taxes are not owed on the rollover amount.
  1. IRA distributions are taxed at ordinary income tax rates, not long-term capital gains tax rates (special lower rates currently apply to long-term capital gains and qualified dividend income).6
  1. The amount rolled over, subsequent contributions and any earnings or dividends remain in the plan tax-deferred.
  1. May pay additional 10% tax penalty for withdrawals before age 59 ½.7
  1. Access to a wide variety of investment choices for asset diversification.
  1. Subject to required minimum distribution rules beginning at age 72.
  1. Can buy or sell shares of any security within the IRA, including any employer stock, without realizing taxable gains or losses.8
  1. Outside of bankruptcy, creditor protection is determined by state laws.
  1. Unlimited federal bankruptcy protection.9
  1. Fees may be higher in an IRA.
  1. Eligible for Roth IRA conversion.
In-kind10 lump-sum distribution11 of some or all of the employer securities to a taxable brokerage account — uses NUA tax treatment (may roll over the rest to an IRA)
  1. Pay long-term capital gains taxes, instead of ordinary income taxes, on any NUA when the securities are sold. This may be particularly useful for individuals who have an immediate cash need (a tax professional can help you assess whether this makes long-term sense for you depending on your current and future tax brackets and expected capital gains rates).12
  1. Must pay ordinary income taxes on the cost basis of the securities in the plan when they are distributed from the employer-sponsored plan.4
  1. Required minimum distribution rules do not apply to the securities that are distributed.
  1. May pay additional 10% tax penalty on the cost basis in the plan for distributions from the employer-sponsored plan prior to age 59½, unless an exception applies.1
  1. IRS early withdrawal penalties not applicable to the NUA portion of the distribution.1
  1. Must meet specific requirements to qualify for special NUA tax treatment. For example, generally only lump-sum distributions4,11 qualify for NUA tax treatment on qualifying employer securities.
  1. Dividends paid on stock can be taxed at a special long-term capital gain rate when paid.
  1. Significant tax advantages may not be realized unless the securities are highly appreciated in value.
  1. May leave your retirement savings over-concentrated in employer stock and therefore, vulnerable to fluctuation in the price of that stock.
  1. Assets in non-qualified accounts generally are not protected from creditors.
  1. Capital gains above the NUA amount may be subject to the 3.8% tax on net investment income.13

J. Bryan Philpott, Investment Adviser Representative

Founder, Aspire Private Capital

J. Bryan Philpott is an Investment Adviser Representative and founder of Aspire Private Capital. He has passed the Series 65 securities exam. Aspire Private Capital is an SEC- Registered Investment Adviser.