Mae West, an iconic 20th century American actress, singer, comedian and sex symbol, reportedly once said “Too much of a good thing is wonderful.”
We’re pretty sure 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 special 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 their 401(k) pretty well, having worked there for almost 31 years from 1977 to 2008. You can substitute your own company if you’d like, or if you have an aversion to XOM or the energy industry.
Upon an employee’s retirement, most of what’s in his or her 401(k) typically goes to an IRA, and continues to grow tax-deferred. Distributions of cash from an IRA are generally taxed at ordinary income tax rates, up to 37% under current law.
If you retire from ExxonMobil and transfer some or all of your ExxonMobil stock from your 401(k) to a taxable brokerage account at retirement, 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 (that’s the “net unrealized appreciation”) until you actually 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 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 to generate income before turning 59½ can be a tax-effective approach, as you’ll only pay capital gains taxes on the appreciation on the stock rather than ordinary income tax plus the penalty on withdrawals from the IRA.
If you’re charitably inclined, you may want to donate your highly appreciated stock directly, or 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 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 large expense, selling NUA stock can be an effective way to do that. It can also be very effective to sell NUA stock in a year in which you have little other income. If you’re in the 10% or 15% tax bracket, it’s possible you may pay nothing in capital gains taxes (under current law). And the IRS excludes the NUA portion of a subsequent sale of the stock 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 not be aware of, but which can save you literally thousands of dollars if done 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.
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. Good companies like ExxonMobil aren’t always good stocks, and the stock market can do bad things to the stocks of good companies. The day before I retired from ExxonMobil (5/1/2008), the stock closed at $93.04/share. Eleven years later, the stock struggles to remain over $70. Holding too much NUA stock can be hazardous to your portfolio’s performance.
NUA stock has to be sold 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/or 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’re planning on keeping shares to bequeath to your children, you may want to consider holding other securities whose basis would be re-set at your death to market value. Those shares could be sold by your heirs 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 it’s possible that holding the dollar equivalent of your NUA shares in a tax-deferred IRA may produce a greater after-tax sum down the road than what you might realize by holding 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 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.
Talk to a competent financial advisor about your particular situation. This is a brief overview of a complicated subject, and your circumstances should be evaluated to determine what’s best for you. Cerity Partners advisors are available to consult with you. Contact Us today.
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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Meet the Author
Doug is a Partner based in the Houston office and a member of the firm’s Wealth Management practice. He is responsible for delivering investment and planning services to clients. His specialty is assisting clients who are approaching retirement to evaluate the options they have as they prepare for the next chapter in their lives.
Prior to joining Cerity Partners, Doug was a Senior Wealth Advisor at Investec Wealth Strategies. Previously, Doug was Manager, Global Benefits Design, at ExxonMobil. He was responsible for the design of corporate benefit programs including pension, 401(k) plan, medical, and insurance plans. He helped design and implement a corporate health strategies program (“Partners in Health”) and a financial literacy program (“Financial Fitness Program”).
Doug earned a BA in psychology from Yale University and received his MBA in industrial relations from the Wharton School of the University of Pennsylvania. He is a CERTIFIED FINANCIAL PLANNER™ professional.
Doug is an active volunteer at The Woodlands Methodist Church and Jubilee Prison Ministry. He and his wife are also members of the National Leadership Council of World Vision USA.