Mae West, an iconic 20th-century American actress, singer, comedian, and sex symbol, reportedly once said: “Too much of a good thing is wonderful.”

Mae wasn’t talking about net unrealized appreciation (NUA). But Mae’s observation raises a valid question. “Can there be too much of this good thing, this NUA?”

“Net unrealized appreciation” refers to a particular tax treatment afforded employer stock in a tax-qualified retirement plan like a 401(k). I’m using ExxonMobil here because I know the company and its 401(k) well, having worked there in HR from 1977 to 2008. You can substitute your own company if you’d like or have an aversion to XOM or the energy industry.

Upon an employee’s retirement, most of what’s in their 401(k) typically goes to an IRA and continues to grow tax-deferred. Distribution of cash from an IRA is generally taxed at ordinary income tax rates, up to 37% under current law.

Suppose you retire from ExxonMobil and transfer some or all of your ExxonMobil stock from your ExxonMobil Savings Plan (EMSP) to a taxable brokerage account. In that case, you may be taxed on the cost basis of the stock (unless you have after-tax contributions that can be allocated to it). But you aren’t taxed on the difference between the cost basis and the market value at distribution (the “net unrealized appreciation”) until you sell the stock. And at that sale, you only pay capital gains taxes (typically 15% or 20%) rather than ordinary income tax.1

Using NUA with employer stock in an investment account makes a lot of sense under certain circumstances:

  • If you retire before 59½, you’ll pay a 10% penalty on taxable withdrawals from your IRA. Selling NUA stock from your brokerage account to generate income before turning 59½ can be tax effective. You’ll only pay capital gains taxes on the stock’s appreciation rather than ordinary income tax plus the withdrawal penalty from the IRA.
  • If you’re charitably inclined, you may donate your highly appreciated stock directly, through a Donor Advised Fund (DAF), or by creating a Charitable Remainder Trust (CRUT). You avoid paying capital gains taxes on the eventual sale of the stock, and you can claim an itemized charitable deduction based on market value on all or part of your donation.
  • If you need to generate a relatively large amount of cash just after retirement for a retirement home or other significant expenses, selling NUA stock in an investment account can be an effective way to do that. Selling NUA stock in a year with little other income can also be tax efficient. If you’re in the 10% or 12% tax bracket, you may pay nothing in capital gains taxes (under current law). And the IRS excludes the NUA portion of a subsequent stock sale from the 3.8% net investment income tax that otherwise may apply to higher-income taxpayers on their investment income. (That’s an arcane tax tidbit that many accountants may need to be made aware of, but it can save you thousands of dollars if executed correctly.)
  • If you’re convinced the stock will appreciate more than your IRA portfolio (taking the different tax rates into consideration), it may make sense to hold the stock in a brokerage account.
  • Having assets outside of your tax-deferred IRA also provides tax diversification. Uncle Sam won’t get a chunk of a withdrawal from your investment account as he would with distributions from an IRA.

But before you jump to the conclusion that the more NUA stock you have, the better, consider why too much can create unanticipated problems:

  • We generally recommend investors have no more than about 5% to 10% of their investable assets tied up in any one position. Concentrated positions can make you wealthy, but if things go south at the wrong time, your plans can be sidetracked for longer than you wish. Good companies like ExxonMobil aren’t always good stocks, and the stock market can do bad things to the stocks of good companies. Holding too much NUA stock can be hazardous to your portfolio’s performance.
  • You have to sell NUA stock to realize its benefits. While paying capital gains taxes is less painful generally than paying ordinary income taxes, those gains can push up your income and result in additional taxes or phase-outs of deductions and exemptions. You should consider the overall tax consequences, not just the difference between ordinary income tax rates and capital gains tax rates.
  • NUA stock does not receive the “step-up” at your death that other marketable securities or property generally receives. If you plan to keep shares to bequeath to your children or grandchildren, you may want to consider holding other securities whose basis would be re-set at your death to market value. Your heirs could sell those shares with little or no taxes due, while they’d owe capital gains taxes on the gain over the cost basis on NUA shares.
  • It can be a complicated analysis, but holding the dollar equivalent of your NUA shares in a tax-deferred IRA may produce a greater after-tax sum down the road than you might realize by having NUA stock in a taxable brokerage account. Dividends on the NUA stock will be taxed as received. Money invested in an IRA grows tax-deferred. Depending on your holding period, rates of return, and marginal tax rates at the time of distribution from the IRA, your IRA may generate a larger after-tax return than your NUA stock, even given the difference between capital gains and ordinary income tax rates.

Other sources say Mae West’s actual quote was, “Too much of a good thing can be taxing.” Again, she wasn’t talking specifically about ExxonMobil NUA stock. But you need to assess how much of a good thing—NUA treatment on employer securities—is good enough and how much may be more than you need or want.

This is a brief overview of a complicated subject, and you should evaluate your circumstances to determine what’s best for you. Talk to a competent financial advisor about your situation. Cerity Partners advisors are available to consult with you. Give us a call or make an appointment. And if you’d like to read other blogs from our website, visit us at https://ceritypartners.com/insights/category/exxonmobil/.

1 There are several requirements that must be met for a distribution of employer securities to be eligible for net unrealized appreciation tax treatment. Consult with your tax or accounting advisor or Human Resources department for more specific rules regarding your plan.

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