Roth Conversion Loophole Closed
IRS issues new guidance
By Kaye A. Thomas
Posted September 9, 2009
NUA is taxable in direct conversion from 401k.
A new notice (PDF) from the IRS offers details on transactions where money moves directly from a 401k or similar account to a Roth IRA. Most of what the notice says is routine, but one piece of it aims to do away with an apparent loophole involving distributions of employer securities.
Distributions from 401k plans are usually made in cash, but they can include employer securities — in other words, stock of the company that maintains the plan. Under certain circumstances, the person receiving the distribution is allowed to exclude the "net unrealized appreciation", or "NUA", from the taxable amount. In other words, the recipient pays tax on what the stock originally cost, not on what it's currently worth. Later, the recipient can sell the shares and treat this appreciation as long-term capital gain, taxed at a lower rate. The catch is that you can't use this benefit if the stock is rolled into an IRA. It's only available if you hold the stock outside an IRA and pay tax on the basis (original cost).
How does this relate to Roth conversions? Before 2008, distributions from 401k and similar accounts could not be directly converted to Roth IRAs. Recipients had to roll the distribution to a traditional IRA, then convert it to a Roth. There was no waiting period between the two actions, but no way to go directly from an employer plan to a Roth IRA. That changed beginning in 2008. People who meet the applicable requirements can do a Roth conversion as part of a rollover from a 401k.
Some experts suggested that this created a loophole for NUA. The reasoning was that the amount taxable on the conversion is equal to the amount that would have been taxable in a distribution from the 401k that isn't rolled over, and that would include only the original cost of the stock. Once the stock is in the Roth, it can be sold tax-free. If the IRA owner follows the rules, all distributions from the Roth will be tax-free as well. As a result, instead of converting NUA to capital gain, the recipient has converted it to tax-free income. It seems reasonably clear that Congress didn't intend to create this benefit (which is why I call it a loophole), but the law as written seems to permit it.
The interpretation given in the IRS notice would block this benefit. The IRS says you have to figure the tax as if the money first went to a traditional IRA and then was converted to a Roth, except we ignore the rules that treat all traditional IRAs as a single IRA (in other words, you're treated as if this deemed IRA were the only IRA you own, even if you actually own one or more other traditional IRAs). The notice specifically states that the special rules relating to net unrealized appreciation do not apply.
The notice doesn't provide strong legal authority for its position. It relies on language in a report prepared by the staff of the Joint Committee on Taxation. These reports don't qualify as official legislative history. What's more, even the official legislative history isn't supposed to be used to contradict language that's clear in the statute. Some tax professionals may choose to challenge the position the IRS has taken in the notice. Many judges are reluctant to side with a taxpayer who is seen as taking advantage of a loophole, however, especially if they acted after the IRS has publicly stated its position to the contrary.
The notice does not state a prospective effective date, and it's possible the IRS will challenge transactions that took place earlier this year, and perhaps even transactions that took place in 2008, even though returns have been filed for those transactions. The notice says the IRS intends to include this guidance in relevant regulations when they are updated.
