With all the buzz about Roth IRA conversions being free of income limits this year, a number of planning strategies have been put forth to capitalize on the tax-free features of the Roth. One such strategy involves rolling an employer's qualified plan directly to a Roth IRA (bypassing the "regular" IRA required prior to 2008) and being able to capitalize upon NUA (net unrealized appreciation) rules regarding appreciated employer stock.
Here is how it works. Say you have $500,000 of your employer's company stock, accumulated over your many years of service. Your actual cost basis in the stock is only $50,000 and the remaining $450,000 is pure appreciation. You have a number of choices:
If you were to leave the stock where it is in your employer's plan and take income from the plan, every dollar taken would be taxed as ordinary income to you. Worst-case scenario, you would cash out the entire plan and take a lump sum check for $500,000 today, owing $175,000 in taxes (assuming a 35 percent tax rate) and netting $325,000 at the end of the day. This would also be the case for a direct rollover to a traditional IRA account - all distributions from the IRA would be fully taxable as income.
The next best scenario is taking advantage of the NUA rules as they exist today, and transferring the company stock to a taxable account. You will be taxed on the original cost of the stock as if it were ordinary income ($17,500 tax in this example) and the remaining $450,000 would be considered taxable as a capital gain. If you decide to take the NUA approach, and then cash out the entire account the following day, the taxes would be $17,500 on the cost basis and $67,500 as capital gains tax (assuming a 15% cap gains rate). This strategy would net you $415,000 after taxes - $90,000 more than the first scenario.
The Roth IRA/NUA conversion strategy is the "having your cake and eating it too" approach. Since 2008, the IRS has allowed you to roll your plan assets as a lump-sum distribution directly to a Roth IRA and be taxed as if you took the distribution "outright" - meaning that you could treat the distribution as taxable only on the stock's cost, and never having to pay the capital gains portion of the tax ever (as all qualified Roth distributions are tax free). This strategy would cost you only the $17,500 tax on the basis, netting you $482,500.
If this sounds too good to be true, that's because it is. The IRS released an opinion in September on this conversion strategy, stating that the direct rollover from an employer plan to a Roth will be taxed as if the money were first rolled through a traditional IRA. In essence, the IRS will tax every dollar going from the plan into the Roth as ordinary income. Not only would you lose the ability to take advantage of the NUA features (you don't get any "do-overs" with NUA - see our previous Boomer articles on the subject), but you will be hit with an additional $157,500 in taxes. You could recharacterize the distribution, and dump it back into a regular IRA account to save on the tax bill, but all future distributions would still be taxed as ordinary income.
Roth conversions can be a great planning tool for your clients, but when it comes to getting the most you can out of the process, be very careful about trying to take more than the IRS is willing to give. 2010 will have many people trying different things and making many mistakes, don't make this one. Any strategy that involves too many moving parts (Roth plus NUA) is bound to have pitfalls for the unwary.
Mark A. Cortazzo, CFP is senior partner with MACRO Consulting Group in Parsippany, N.J.