Summary: NUA can be a good option for some company stock in the Exxon 401(k), but it can also trigger a higher tax bill if it’s not planned properly. It’s important to understand how to prescribe your opportunity (or lack of) with the shares in your 401k. When it makes sense, NUA is a fantastic way to locate assets in a more tax-favorable position. How do you make a good decision around your NUA opportunity? It requires significant knowledge of the rules around NUA, an understanding of your situation and the rest of your assets. Enjoy!
Our tax code is long — thousands of pages. Technically, the actual tax code isn’t terribly long (few thousand pages), but when we include all of the pages about the tax code, it’s over 70,000 pages. That, in and of itself, gives insight into its complexity. All of those pages are needed.
In my opinion, NUA is one of the strangest parts of the entire tax code.
I’ll admit, I’m a CFP professional. I’m not a CPA. I’m not trying to be an expert on the entire tax code. I’ve devoted almost all of my research on taxes only to the parts of the tax code that affect the typical client in my niche-Oil & Gas and Petrochemical retirees. So, of the tax areas that affect my typical reader coming from a large Oil & Gas firm, NUA is about as weird as it gets.
What’s my goal with this article? I want you to understand your NUA opportunity AND where it fits in with the rest of your financial life and retirement plan.
Your HR department provides terrific seminars on the topic. The problem is, you maybe attended one three years ago, can’t remember much, and you probably aren’t sure where it fits in with the other pieces of your retirement puzzle. Life’s busy. I don’t expect you to remember your exact allocation to small caps in your 401k, much less the cost basis in your NUA opportunity and what that means for you. So, let’s address what NUA is, address some common mistakes, and talk through how you should be planning around it.
What is NUA
Net Unrealized Appreciation. It’s pretty sensical when you break it down. You have XOM shares inside of your 401k. Some of those shares have appreciated substantially while inside of your 401k. The IRS saw a problem with this decades ago. After all, your 401k is subject to income tax (assuming pre-tax instead of Roth 401k). Income tax is a lot worse than the tax levied on after-tax stock positions. Holding XOM in an after-tax brokerage account affords you qualified dividends and capital gains tax treatment. But, holding anything in a 401k subjects that holding, and all of the future growth, to income tax.
This picture should help. To put it simply, many of you may face 22/24/32+% tax brackets with your future distributions from your pre-tax retirement plan (401k or IRA). But your assets in an after-tax brokerage account may only see the gains taxed at 15/18.8/23.8% (for some of you, maybe 0% in some years if we plan properly). Why is NUA a great opportunity? We’re moving assets from the red (more tax) to the blue (less tax). A big part of your retirement is tax planning with your assets to transition from the red to the blue–and especially to the tax-free green (Roth).
Really goofy aspects of NUA that cause the most mistakes
You must understand these. NUA is an opportunity for you, but the IRS made it really sensitive.
-You get one shot, so don’t take distributions without considering this. Your NUA distribution opportunity goes away if you take a distribution (RMD or normal) without doing the NUA at the same time. So, you need to approach retirement with an understanding and plan of how you’re going to distribute your 401k. If you’re within five years of retirement and you own significant NUA-eligible shares, you should meet with a fee-only advisor with expertise in this area.
-Be careful when liquidating your XOM stock before retirement.
You should be wary about holding too much XOM. Your financial livelihood already revolves around Exxon because they’re your employer. So, don’t put too much stake in your future financial livelihood there as well. BUT, if you’re diversifying out of XOM, you don’t want to sell shares that you bought 30 years ago if you can avoid it. NUA is really valuable on $10 shares with a current market price several times that number. It’s not valuable on $60 shares you purchased more recently.
-NUA shares are NOT given a step-up in basis upon death
This is probably the factor that makes NUA so strange. Virtually every other asset you own in life (outside of a retirement account) will receive a step-up in cost basis when you pass away. That’s right. If you had the foresight to buy a couple of acres in River Oaks 50 years ago, you could wait until you pass away and your children can sell it virtually tax-free. Even if you bought the land for $50,000, their cost basis gets a bump to whatever the market value is at your death. This is also true with any other stock you own. This is not true with NUA. Your cost basis stays with the XOM shares into the next generation. This could make some of those shares excellent candidates for charitable giving.
Strategy to maximize your NUA opportunity
As I mentioned, NUA is exciting if we’re talking about shares purchased at a fraction of the XOM’s current market value. Inevitably, this means shares that you purchased decades ago. Before we even begin, one important consideration: just how much XOM should you own after everything is settled? I talk a lot about tax efficiency because it is critical in this process, but let’s not make a bad investment decision just because it has a tax benefit. That’s why financial planning is a process that includes both areas. Now onto the main event: How do we maximize your NUA opportunity?
First, understand which shares are not a good NUA opportunity
Remember my whiteboard drawing above with the three tax buckets? It’s important to understand that NUA distributions are not a tax-free event. We are triggering income tax. And on the back-end, it’s still not tax-free. You will still be subject to tax on qualified dividends and capital gains when you sell.
I mention this because, as you can tell, you do not want to do an NUA distribution on every available share. NUA is a great opportunity. But remember the above paragraph, it needs to be so good that it’s worth paying some income tax now and still being subject to capital gains later. More detail on that in the next paragraph…
Second, understand the cutoff that makes it worth using NUA
Because of point #1, we then have to decide which shares we should pinpoint for an NUA distribution. On your 401k statement, you have that page devoted to all of the XOM shares you have purchased and which source they came from (pre-tax, match, after-tax, etc.). While I only give specific advice to clients that are in an advisory agreement with my firm, it makes a lot of sense NOT to utilize NUA on $50 cost basis shares. As your cost basis gets to less than half of the current market price, those are shares you may want to NUA. So, if XOM gets to $70, a $25 share could be a great fit for NUA, while a $45 share isn’t as great. In addition, remember the question I posed above: just how much XOM should you have at the end of this process? If you have $7 Million in total assets, it might be reasonable to NUA $350,000 and liquidate the rest of your XOM in your IRA to diversify. If you have $3Million in total assets and you’re wanting to keep $1Million in XOM, that’s a lot of uncompensated risk that you should likely avoid. Notice what I said there-the NUA shares arrive in an after-tax brokerage account. But, your other shares (that you do not elect for an NUA distribution on) are sent to your pre-tax IRA. Those shares in your IRA should likely be sold and diversified.
Third, understand where it fits into your tax return and future tax years
Remember my first point–NUA distributions are triggering an income tax bill in the year you do it. So, it needs to be properly planned. For many of you, you shouldn’t do your NUA distribution in the year you retire. As you can imagine, if you retire in October, you’ve already earned significant income. Most of you are retiring from Exxon with the highest income in your career. So, we want to be mindful of when to execute the NUA distribution so that we stay close to an efficient tax equilibrium rate.
What type of tax bill are you looking at?
If you still have a lot of XOM shares in your 401k, and you started purchasing shares in the ’80s and ’90s, you may have a few hundred thousand dollars worth of shares you want to utilize NUA with. Let’s pretend that you have $1,000,000 in XOM total and are NUAing $400,000 out of the 401k to a brokerage account. We’ll pretend the cost basis on that $400,000 is a total of $160,000. Before accounting for after-tax funds, this will trigger $160,000 in taxable income during the calendar year that you execute the NUA transaction. So, if you retire this fall and wait to do your NUA transaction until January 2021-your 2021 income will include the cost basis of the NUA shares ($160,000).
Now, let’s assume you have made after-tax contributions in your 401k throughout your career–we’ll say $90,000. These after-tax 401k funds can be a tremendous asset offering you flexibility.
You could take the $90,000 out tax-free
You could apply the $90,000 to the cost basis. So, your taxable income would be $70,000 instead of $160,000.
You could send the after-tax portion to a Roth IRA during the rollover.
So, you NUA the $400,000 XOM to an after-tax account which triggers reportable income of $160,000, you send the $90,000 to a Roth IRA where it grows tax-free, and the rest of your account goes to a Rollover or Traditional IRA (pre-tax IRA).
If your plan allows, some sort of combination of the above options.
Where does this fit in with other retirement tax planning items-like Roth conversions?
What we’re now doing is figuring out your optimal tax equilibrium rate throughout retirement. This is going to be different for every client I work with, but here are some educational guidelines. As I point out in this video, you probably are retiring from a high income. You likely have a few years until you have to take Social Security (70 at latest) and several years until the IRS forces you to take a portion from your pre-tax IRA in required minimum distributions (72 now thanks to the Secure Act).
As mentioned, your NUA distribution and rollover will potentially trigger some serious taxable income. So, it matters how much income you’ve already made in the year you retire.
What you should do is based on your unique situation. As a general rule, NUA is a great option if you want to continue to hold some of that stock long-term (or gift it) and you only NUA shares that have significantly appreciated. Keep in mind your NUA shares are not growing tax-free thereafter. So, is it as valuable as a Roth conversion? In some ways, no.
You have to think through several considerations:
Your total assets, and how much you have in pre-tax vs. after-tax
How much time do you have until SS and RMD income begins?
How many kids you have. Even more specific: how many different people will be inheriting your assets? What will their income be in the future?
If you have two children that will likely have fruitful careers with high incomes, the SECURE Act means that your IRA will be taxed heavily when they inherit it. This helps you decide whether Roth conversions should be limited to the 10/12% brackets or extend into the 22/24% brackets.
Age of your spouse-Specifically, the likelihood that one of you will significantly outlive the other
I’ve worked on several cases where one spouse is much younger. This can make Roth assets even more valuable. After all, your spouse can inherit your Roth in their own Roth and continue tax-free growth. Your kids inherit a Roth in an after-tax account (they cannot continue to enjoy tax-free growth after inheriting your Roth)
Clear as mud, right? NUA is a fun piece of the retirement puzzle. Doing it right can be a big help. Doing it wrong (whether ignoring it or using it on way too many shares) is not helpful at all. If you have any questions, shoot me an email or phone call in the Contact Us tab.
If you want to learn more about some of the other opportunities related to the ExxonMobil 401(k), we wrote another article going into greater detail about other aspects of the plan here.