By David Chazin
Does your ESIP account include shares of Chevron stock that have grown a lot since you acquired them? If you answered “no”, you’re probably the only Chevron employee who can say that. For everyone else, you may be able to make use of an important tax reduction strategy when you retire or otherwise leave Chevron.
To better understand it, net unrealized appreciation (or NUA) is the difference between the market value of your Chevron shares on the date they are distributed to you and the date they were originally added to your ESIP. To use the NUA strategy, you have to: leave Chevron, receive a lump-sum distribution of your account’s entire balance in a single year, and choose to take all or some of your Chevron stock “in kind.” That means you take the actual shares instead of a check for their value or rolling them over into an individual retirement account (IRA). You just need to have your shares transferred to a taxable brokerage account and NOT have them roll over into an IRA.
Taking your Chevron shares “in kind” creates a three-way withdrawal. First, you pay tax on the stock at your ordinary-income rate based on the distribution from the ESIP. But you pay tax only on the cost basis (or value when you received the shares), not on the NUA. This plan works best for monies distributed after 59 ½ and when taxes due on the “in kind” transfer are paid with non-retirement account monies. The NUA will only be taxed when you or your heirs sell the shares.
Second, when you sell your Chevron shares, you pay the tax on the NUA at the long-term capital gains rate even if you do not hold the stock otherwise required for the long term capital gain treatment. Currently, the maximum rate on long-term capital gains (15%) is lower than the maximum rate on ordinary income (up to 35%). Any growth after you receive the distribution from your ESIP is taxed at your capital gains rate — either short-term or long-term, depending on if the sale or the distribution are more than one year apart. Keep in mind that capital gains and ordinary income tax rates may be subject to change in the future.
Third, if you take the distribution before age 55, any early 10% withdrawal penalty on the company stock applies only to your cost basis, not to the NUA.
And fourth, at age 70½, you must begin required minimum distributions (RMD’s) from an IRA. You can hold your Chevron stock indefinitely if it’s in a taxable account.
By taking the Chevron stock you are exposed to market risk and may have the potential for a loss. Market risk is the exposure to the uncertain market value of the stock, and the potential for a holder to experience losses from the fluctuations in a stock’s price. This risk cannot be diversified away if you hold onto your Chevron stock.
You also need to consider your overall asset allocation. When deciding what to do with company stock, focus on your total portfolio investment objectives, asset allocation and Chevron’s future prospects. The rationale is that an “in kind” transfer may raise your portfolio’s risk and volatility, making it riskier, at a time when you probably want to reduce risk, especially as you near retirement. If you take the Chevron stock as shares, you may have to adjust your retirement portfolio’s asset allocation to help keep its risk level in check.
A Practical Application
What would happen if you follow the usual advice to preserve your tax deferral by rolling over your retirement plan distribution to an IRA? All distributions from an IRA are taxed as ordinary income. So, including your Chevron stock in the rollover means losing the capital gains rate advantage for its NUA, which is an opportunity you can never have back.
Here’s a simple example of an NUA strategy. Assume you’re age 60 and planning to retire soon. You expect to be in the 35% tax bracket after you retire. You have a $600,000 balance in your ESIP account — $400,000 in Chevron stock with a cost basis of $100,000 and the remaining $200,000 in various Vanguard mutual funds.
If you roll over the entire balance into an IRA, you won’t pay any taxes immediately. You lose the NUA opportunity once the stock is deposited into the IRA. Eventually, you’ll pay up to 35% (or your ordinary income rate then if different) of every dollar distributed from your IRA, and you’ll have to eventually take required minimum distributions.
If you take the $400,000 worth of stock “in kind” when you retire and roll over just the $200,000 into an IRA, you’ll pay approximately $35,000 federal income tax on the $100,000 cost basis of the stock. But you’ll defer all the taxes on the $300,000 NUA until you decide to sell the shares (and on the $200,000 IRA until you take distributions). When you sell your Chevron stock, you’ll pay the maximum capital gains rate in effect then on both the NUA and any growth that occurs after the distribution.
Based on our example, you could gain approximately 20% (the difference between the current federal ordinary income tax and capital gains tax) of the NUA or $60,000. The process of taking advantage of this NUA strategy when you retire is complicated and you only get one chance to get it right, so it’s important that you have someone making sure you do this right, or you’d pay the extra $60,000.
We’d be happy to arrange a meeting with you to review your ESIP allocation and help you balance diversification with the NUA strategy, which is especially important for Chevron employees nearing retirement. Because we work with many Chevron executives, managers, employees and retirees, we’re very knowledgeable about your various compensation plans and benefit offerings, plus other issues specific to Chevron employees (in addition to the retirement, investment, and estate planning issues everybody faces). In fact, chances are you may know one of our Chevron clients and you can ask them how working with an advisor has helped them.
Please contact us at (925) 659-8020 with specific questions or to schedule a time to meet in our San Ramon, Point Richmond or Houston, TX offices.
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