Net unrealized appreciation (NUA) is a little known rule that can potentially result in tax savings on your company stock! NUA is an option for any employee who accumulates employer shares in their retirement plan.
If you are a professional in the oil & gas industry, chances are you’ve heard of NUA. If you are unfamiliar with this term, you’ll likely hear about it as you accumulate company stock in your retirement plan. In a nutshell, NUA is a special tax treatment that allows plan participants to extract employer stock out of a retirement plan, pay ordinary income tax on the cost basis, and the appreciated amount is then taxable at a more favorable long term capital gains rate.
Current stock price – what you paid for the stock = NUA
It’s common for large oil & gas companies, and other major industries, to reward employees with stock. This can be through profit sharing plans, an ESOP, or share purchases inside of a 401k. If you are an employee of Exxon, Chevron, ConocoPhillips, OXY or any other large player in the industry, you have seen the net unrealized appreciation section in the plan documents. As you accumulate employer stock, this creates an opportunity for potential tax savings, but it can cause unwanted consequences if not planned correctly.
This post will lay the foundation and in the near future, I will take a deep dive into specifics using NUA.
First, determine if NUA an option. As a rule of thumb, NUA makes sense if:
Note: There are some circumstances where NUA can make sense on securities that have little appreciation. These planning opportunities are unique and depend on other financial assets as well as retirement needs.
If you have decided NUA is worth exploring, read on.
There are three requirements to use NUA as a strategy.
Note: A partial distribution after a triggering event can disqualify you from NUA. However, if another triggering event occurs, this can open the door for NUA treatment again.
The nuts and bolts of net unrealized appreciation are easier explained by a visual, as shown below in the graphic from Michael Kitces. When you distribute funds from a traditional style retirement account, such as a 401k, you pay ordinary income tax. NUA treatment allows you to pay ordinary tax on the cost basis of your employer stock. This results in ordinary income tax in that year on the amount of the basis. The remaining appreciated amount (NUA) is moved to a taxable account where it receives a more favorable long term capital gains rate when sold.
The long term capital gains tax rate is 0%, 15%, or 20% depending on your financial situation. The majority of people fall into the 15% rate. After the shares are moved to the taxable account, any additional appreciation above the NUA is taxable at long or short term gains depending on the holding period. The main point here is that NUA allows the appreciated amount above the cost basis to receive long term capital gains tax, regardless of the holding period. NUA is taxable when the shares are sold.
John worked for Exxon and recently retired. Over the years, he has purchased $200,000 of XOM stock in his retirement plan. The value of the shares has grown to $600,000. This amount or partial amounts would be taxed at ordinary income when John takes a distribution. Instead of being taxed at the ordinary income tax rate, John has the ability to use NUA treatment on XOM stock.
The NUA in this example is $400,000 ($600,000 current value of XOM stock minus the $200,000 cost basis). The basis of $200,000 is taxable as ordinary income in the current year. The NUA amount of $400,000 is taxable as long term capital gains when sold.
To break down this example further, let’s assume John has a tax rate of 24% and pays 15% on long term capital gains.
NUA: John pays a total tax of $108,000. $48,000 ordinary tax and $60,000 long term gains (.24 x $200,000 plus .15 x $400,000).
Ordinary tax: John pays a total tax of $144,000 (.24 x $600,000).
Tax savings: $36,000. John likely wouldn’t take a lump sum from a retirement account and pay tax all at once, but this illustrates the potential tax savings using NUA treatment.
Note: If you use NUA before age 59 1/2, you may incur a 10% penalty.
Using NUA treatment comes down to what fits best with your financial plan. Taxes play an important role at any stage in your career. With proper planning, strategies like NUA can not only give less money to Uncle Sam, but also diversify your exposure to higher taxes down the road.
A final note on NUA considerations. Don’t elect for NUA treatment simply because of taxes. Give priority to what’s best for your financial goals. Align your asset allocation to your risk preference and capacity. Then determine the best course of action from a tax planning standpoint. I will write about NUA is more detail along with strategies and what to look out for in the future. Be sure to work with a professional that understands your industry before taking action on net unrealized appreciation. If you need help navigating NUA with your oil & gas company stock, we are here.