There are many good papers already written on the subject of NUA. Why does the world need another one? I have found that many people read about, or take in a seminar on, NUA and still feel like they are missing the “essence” of the subject. I believe the following gets to the essence of the subject simply and quickly. I will forego the details, because they are covered perfectly well elsewhere.
The first thing to know about NUA – even before knowing what the initials stand for – is that it is a tax trick. It is one way to reduce the taxes you pay in retirement. The trick has value for the vast majority of ExxonMobil retirees. It does not have value for everyone.
NUA stands for “Net Unrealized Appreciation”. If that means nothing at all to you, don’t worry. Indeed, the words do not explain the tax trick. I will explain both the words, and the tax trick, below.
In order to understand NUA, you must understand the fundamental differences between a “qualified” plan (like a 401k) and a normal, every-day, plain-vanilla investment account.
Let’s start with your 401k. The deal you made with the government was as follows:
- You elected to put a part of your salary into the account on a pre-tax basis, and the government agreed to pretend like you never received this as income; therefore, you saved on taxes every year while you saved for retirement.
- In addition, you paid no tax on annual gains (appreciation) – if any – until you start to withdraw money from the account
- Just to sweeten the pot, you get a company match!
- In return for paying less tax while working, you agreed on some restrictions
- A tax penalty if you take the money out “early” (prior to retirement or age 59½)
- Every dollar – both the amount you invested, plus the gains (appreciation) over time – would be taxed as “ordinary income” (the highest rates there are; more about that later)
- You promise to take the money out (and pay taxes on it) during retirement. To enforce this promise, the government sets a schedule for Required Minimum Distributions (RMDs) starting after age 70; and, charges a 50% tax penalty for failure to withdraw.
Despite the restrictions, the Traditional 401k is a good deal. Besides the tax savings, you also got the company match.
But, let’s compare this with what would have happened had you decided to ignore the 401k. And, let’s just consider buying XOM stock in a brokerage account. Nothing else.
- You will pay tax on all your income now.
- You will pay tax on the dividends as they come in every quarter.
- You get no company match.
- Just like in the 401k, you pay not tax on annual gains – if any. In the 401k, you only owe tax when you remove money from the account. In the brokerage account, you owe tax when you sell the shares (you “realize” the gain for tax purposes) whether you remove money from the account or not.
- You can see that there are downsides to using a brokerage account. The benefits are:
- When you sell shares that have appreciated in value, you pay capital gains tax instead of “ordinary” tax rates. If capital gains are “long term” (you held the stock for more than one year) the tax is always less; typically, about 40% lower than ordinary tax rates.
- There are no tax penalties for “early withdrawal”; it is your money to use when you want it.
- There are no RMDs; it is yours to save forever or pass on to the next generation.
OK. You did not do it that way. You used the Savings Plan. Good! That was the right decision. Now that you understand the two types of accounts, let’s get on with the story.
Let’s say that one day you are looking at your Savings Plan statement. You notice that you have a whole bunch of XOM shares at $15/share or less. And you wish you had purchased those shares (and *just* those shares) in a brokerage account a long, long time ago.
Feeling crazy, you decide you have nothing to lose, so you write a letter to the IRS and tell them you would like a “do-over” on those shares (and *just* those shares). You will agree to pay tax on the original cost of the shares (as ordinary income – just as it would have been had you bought them in a brokerage account all those years ago); and move those shares out of your Savings Plan (401k) into a brokerage account. You hope they will not notice that if you had purchased the shares in a brokerage account, you would have paid tax many years ago.
To your utter surprise, the IRS says “OK”. You can have your “do-over”, because it falls under a section of the tax code referred to as “NUA”. There just a couple of strings attached:
- The “do-over” (NUA) can only apply to your employer’s stock; but, it can include stock received as the company “match”
- It must be part of a “lump sum distribution” of the 401k, meaning:
- It is the first distribution since a “qualifying event”:
- Separation from service after age 55
- Attaining age 59½
- You remove *everything* from the 401k
- Anything that you do not take as NUA can be rolled to an IRA
- Must be nothing left in the 401k at the end of the calendar year
- It is the first distribution since a “qualifying event”:
Note: you can replace $15 in the illustration above with any number you like; however, the lowest cost shares always have the most value for NUA treatment.
In summary, why do people find it advantageous to use this NUA “do-over” trick?
- The main reason is that they can save tax when they sell the XOM shares. The NET difference between the APPRECIATED value of the stock and its original cost basis will be taxed at capital gains rates instead of ordinary income tax rates when the gain is REALIZED at time of sale.
- A secondary advantage is to move these assets from “qualified” accounts (401k and IRA) to normal (“non-qualified” accounts) so that there be no RMD later in life.
- For those retiring before age 59½, another advantage is to eliminate the tax penalty for “early” distribution. Although, this should not be a primary reason – because other exceptions to the tax penalty could apply. Still, NUA is often the best and most tax-efficient means of funding early retirement.
If you are wondering: why would the IRS be willing to make this deal? Don’t. The tax code does not need to make any sense. It is what it is. It favors certain things and disfavors other things and has unintended consequences frequently. In this case, it is favoring people who invest in their employer’s stock. Maybe that was the intention; maybe not. It does not matter.
The single biggest misunderstanding people have about NUA is: they think that in order to make the distribution from the Savings Plan and exercise NUA, they must sell the XOM shares. Not true. It is a simple readjustment. One day the XOM shares are in the Savings Plan. You make the distribution and voila! The XOM shares are now in a brokerage account. Any XOM shares that you did *not* take as NUA, can be rolled over to an IRA as XOM shares. There is no need to sell any XOM shares at all.
The most frequent question about NUA is: do I have to do it immediately after retirement? No. Most people *do* exercise NUA immediately after retirement. Some people delay for a year or 3. Some do not exercise NUA at all. If you are going to take NUA, the last opportunity is the year after you turn 70½. Why? Remember that to do NUA it must be part of a lump sum distribution, which must be the first distribution made following a qualifying event. And, remember that after age 70 RMDs will force you to make a distribution from your Savings Plan. Therefore, if you have not touched your Savings Plan between retirement and age 70½, then decision time has come. Most people who do NUA, do it right away.
The “best” time to do NUA depends on the individual situation. Without getting into the details (which are covered perfectly well in other places), I cannot even begin to explain what it depends on. To keep with the intent of this document: to be simple and quick; I will say that the NUA decision needs to be integrated into the overall financial plan.