You may or may not be familiar with the concept of Net Unrealized Appreciation (NUA) as it relates to company stock owned in your 401(k) plan. Click the link to get a rundown on it if you’re not familiar with NUA.
Briefly, when you take distribution from your 401(k) you can rollover everything but the company stock (your company) to an IRA, and then put the company stock in a taxable account. By doing this, you pay tax only on the basis of the company stock, and in the future you will only have to pay capital gains tax on the sale of the company stock, rather than ordinary income tax as you would if the company stock (or the proceeds) were in a traditional IRA.
[See Jim’s tips on Paying Taxes on a Roth IRA Conversion]
Now, let’s toss in the Roth Conversion concept – you pay tax on the amount that would be otherwise taxable if the distribution were in cash, but you place the funds in a Roth IRA account, and you don’t have to pay tax on it in the future at all (as long as you meet the qualifications).
How do these two concepts work together? Well, at one time, it was thought that you could work both sides of the coin and utilize the loophole: if you converted the company stock directly to the Roth, it seems that you would only have to pay tax on the basis of the stock (per NUA rules), and then never have to pay tax on the capital gains. This is because the stock is held in a Roth IRA.
Not so fast, though. The IRS figured this out pretty quickly after the rules for conversion from a qualified plan to a Roth IRA were put into effect in 2009. For this specific circumstance, you must treat the Roth conversion from a qualified plan as if it were first rolled over to a traditional IRA, and then converted to a Roth IRA. The one exception to the way this is handled is that you only have to consider the qualified plan’s funds that you’re converting – rather than all of your IRAs as you would normally (cream in the coffee rule) – for tax purposes.
This results in having to pay ordinary income tax on the entire value of your company stock holdings if you do such a conversion (rather than just the basis). So it may still be to your benefit to enact the NUA rule and put the company stock into a taxable account rather than an IRA – but you’ll have to run the numbers to figure out if this will work best for you.