NUA lump-sum treatment with §404(k) dividend pass-throughs

Quick answer: For 2025, periodic § 404(k) dividend pass-through payments do not disqualify a later lump-sum distribution of the account balance from lump-sum treatment. The regulations treat a deductible dividend as paid under a "separate contract" from the rest of the plan, so it is analyzed independently of the balance-to-credit determination that governs whether the eventual distribution is a lump sum under IRC § 402(e)(4).

What it is

Net unrealized appreciation (NUA) treatment lets a participant exclude from ordinary income, at the time of a lump-sum distribution, the appreciation on employer securities attributable to employer contributions — that gain is deferred and taxed later, generally as long-term capital gain, when the securities are sold. For purposes of subsection (a) and section 72, in the case of any lump sum distribution which includes securities of the employer corporation, there shall be excluded from gross income the net unrealized appreciation attributable to that part of the distribution which consists of securities of the employer corporation.¹

That exclusion is only available if the distribution qualifies as a "lump-sum distribution," which IRC § 402(e)(4)(D) defines as the distribution or payment within one taxable year of the recipient of the balance to the credit of an employee which becomes payable to the recipient on account of death, after attaining age 59½, on account of separation from service, or after becoming disabled, from a trust which forms a part of a plan described in section 401(a) and which is exempt from tax under section 501 or from a plan described in section 403(a).² This is separate from § 404(k), which governs a corporation's deduction for ESOP dividends paid on employer securities — a different Code provision addressing a different taxpayer's tax treatment (the employer's deduction, not the employee's income inclusion).

How it works — why periodic dividends don't disqualify the lump sum

The key mechanical question is whether § 404(k) dividend payments are counted as part of "the balance to the credit of the employee" for lump-sum-distribution purposes. IRC § 402(e)(4)(D)(ii) requires aggregating certain trusts and plans in determining that balance, but the regulations carve dividend pass-throughs out of the ordinary plan-distribution framework. Treas. Reg. § 1.404(k)-1T, last amended in 1986, directly addresses this: a deductible dividend under section 404(k) is treated for purposes of section 72 as paid under a contract separate from any other contract that is part of the plan. Thus, a deductible dividend is treated as a plan distribution and as paid under a separate contract providing only for payment of deductible dividends. Therefore, a deductible dividend under section 404(k) is a taxable plan distribution even though an employee has unrecovered employee contributions or basis in the plan.³

Because the dividend is legally a distribution under a separate contract, it is not "the balance to the credit of the employee" being paid out under the main plan contract in a single taxable-year lump sum — it's a distinct, independently taxable stream. This regulation is a Temporary regulation dated 1986 and predates § 404(k)'s more recent amendments, so confirm the current statutory language, provided at IRC § 404(k)(2)(A), still lines up: it defines an "applicable dividend" as one paid in cash to the participants in the plan or their beneficiaries, or paid to the plan and distributed in cash to participants in the plan or their beneficiaries not later than 90 days after the close of the plan year in which paid⁴ — confirming these are cash pass-throughs, structurally distinct from account-balance distributions.

Risks and limits

• No IRC § 402(e)(4) provision, Treas. Reg. § 1.402(a)-1, or Treas. Reg. § 1.402(c)-2 excerpt provided here expressly cross-references § 404(k) dividends as a disqualifying "prior distribution" that breaks up the "within one taxable year" balance-to-credit requirement. The documents do not show a ruling squarely on point applying § 402(e)(4) aggregation to § 404(k) dividends beyond the 1986 Q&A.
• Treas. Reg. § 1.402(c)-2(d)(3), addressing rollover-eligibility mechanics for "substantially equal periodic payments," shows the IRS's general approach to characterizing recurring payments alongside a later balance distribution — if the amount (or method of calculating the amount) of the payments changes so that subsequent payments are not substantially equal to prior payments, then a new determination must be made as to whether the remaining payments are a series of substantially equal periodic payments over a period specified.⁵ This confirms the IRS treats different payment streams independently rather than collapsing them, consistent with the separate-contract theory for § 404(k) dividends, but it is not a direct ruling on NUA/lump-sum qualification.
• The Treas. Reg. § 1.404(k)-1T text is nearly 40 years old (1986) and is Temporary; if § 404(k) or § 402(e)(4) has been amended since to address this interaction directly, that amendment would control over this older regulation.

In practice

Based strictly on the documents: the separate-contract characterization in Treas. Reg. § 1.404(k)-1T supports the conclusion that periodic § 404(k) dividend pass-throughs, paid apart from the account balance, do not count against or break up the "balance to the credit of the employee" distributed as a lump sum, and so should not by themselves disqualify the later distribution from lump-sum/NUA treatment under § 402(e)(4). However, this is a narrow regulatory inference rather than a ruling squarely on the fact pattern, and it rests on a regulation older than many later Code amendments.

Given the stakes of an NUA election and the age of the controlling regulation, this is a fact-specific issue worth confirming with a CPA or ERISA counsel who can review the actual plan document and distribution history before the election is made — this response is general information, not advice on your specific plan.