This is a question we frequently get when meeting with Chevron employees. The answer is fairly simple, yet the implications of misunderstanding the difference could cost a retiree thousands in taxes at retirement.
Chevron Common shares
The Chevron Common shares you hold in your Chevron Employee Savings Investment Plan (ESIP) (better known as 401(k)) are shares you purchased over time with your own ESIP contributions or cash from matching contributions.
The ESOP shares are a different story. In December 1989, Chevron formed an Employee Stock Ownership Plan (ESOP) and borrowed $1 billion to purchase shares of Chevron stock. As the loan was paid off, shares were released from the ESOP and deposited into the 401(k) as employee matching contributions. This continued until October 2013 when the ESOP ran out of shares. Chevron then went back to making matching contributions in cash.
Why does this matter?
Both kinds of Chevron shares held in the 401(k) have the same price per share, so to the average Chevron employee, they are essentially the same investment. This is true with the exception of a couple of very key differences as it relates to Net Unrealized Appreciation (NUA).
There are many rules that have to be followed for the NUA to be used, but essentially NUA is a one-time opportunity that allows a retiring person to remove shares of company stock from their 401(k) and deposit them into a non-IRA brokerage account and pay taxes only on the cost basis of the shares, which is the amount of the original purchase price. Normally, every dollar pulled from your retirement account would be taxed at ordinary income rates. Some Chevron employees hold a lot of Chevron stock in their 401(k), so there are potentially huge tax benefits of being able to remove a significant portion of that account and only be taxed on a portion of the total value.
Shares and the NUA
Let’s take a look at Hank Smith (a fictional composite of typical Chevron retirees we encounter) to see some examples of how the ESOP and Common shares are treated when NUA is used. He is 60 years old and holds Chevron stock in his 401(k), which has 200 Common shares with an average cost basis of $60 a share. He also holds 100 ESOP shares with a cost basis of $17.70 a share. And CVX is currently trading at $100.
The Chevron Common shares are simple to understand, because Hank’s cost basis is what Hank paid for them. If Hank wanted to use NUA on his 200 Common shares at a price of $100 and his average cost basis of $60, he would remove the 200 shares worth $20,000, deposit them in a brokerage account, be taxed on the $12,000 cost basis, and avoid immediate taxation on the $8,000 difference between the cost basis and market value. The $8,000 difference is the NUA portion of this distribution and is converted to unrealized long-term capital gains (LTCG) that would be taxed only if the shares are ever sold, and at the LTCG rate if so, which is typically going to be lower than ordinary income rates.
Since the ESOP shares were bought by the plan in 1989 and were deposited as matching contributions, Hank’s cost basis in the ESOP shares is the 1989 cost of $17.70 a share. If he wanted to use NUA on his 100 ESOP shares valued at $100 a share, he would have to pay ordinary income taxes on only about $1,770 and the difference of $8,230 would be converted to unrealized LTCG.
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For most Chevron retirees, the ESOP shares will have a much lower cost basis than the Common shares and therefore be the more attractive NUA option. That is unless that retiree has a tax-paid balance (TPB) in their 401(k). Tax-paid balance (referred to by Vanguard as “after-tax cost basis”) is money that you put into your 401(k) that was not-tax deductible. This can be contributions before 1987, when contributions were not deductible, or contributions that went above the annual IRS prescribed limits for deductibility. You can find your TPB, if any, on your Vanguard quarterly statement under “After-tax details.”
When Hank retires, Vanguard will give him several options with what to do with his TPB. He can take it as cash, roll it to a Roth IRA, or he can apply it towards the cost basis on his Common shares for NUA. This last option can really provide some tax-savings over the long-term. For example, if Hank had $3,000 of TPB and wanted to use NUA on the same 200 Common shares with a $60 average cost basis, he could apply his TPB. He would remove the same $20,000 of Chevron Common shares, but be taxed at ordinary income rates on only $9,000 because the $3,000 TPB reduced the taxable portion of NUA from the original $12,000 cost basis. If the TPB were large enough, it could offset the entire cost basis of his Common shares, or he could choose to only use NUA on the number of shares for which his TPB covers the cost basis, resulting in a tax-free distribution of Chevron shares at the time of retirement.
This leads us to the final major difference between Common and ESOP shares: TPB cannot be applied to ESOP shares to offset ordinary income on the cost basis of the shares. Although this is a disadvantage of using NUA on the ESOP shares, they still typically have a much lower cost basis than Common shares, and it often makes sense to still use NUA to remove ESOP shares even if it means paying some tax.
Instead of using NUA on all of his Common shares, Hank decides that he will only use NUA to distribute the amount that will be offset by his TPB. The $3,000 TPB will cover the cost basis of 50 of his Common shares at a $60 cost basis. These 50 shares, valued at $5,000, will be removed from the 401(k) with no immediate tax consequences. Hank also decides he will use NUA to distribute all 100 of his ESOP shares as in the previous example. The results of both strategies have him removing 150 total Chevron shares valued at $15,000 but only paying taxes on the $1,770 ESOP cost basis.
Hank’s example shows the math of how NUA works in regards to the different share classes. It is not uncommon for us to see Chevron retirees with thousands of shares of both classes and tens of thousands of TPB to use towards NUA. When you look at Hank’s examples, he saved thousands in taxes by using the NUA strategy. Imagine what happens when you multiply the shares and TPB amount several times over.
These examples show how NUA works, but they are not a recommendation. Many of our clients combine different strategies to get the most advantage out of NUA. For others, it makes sense to not use NUA at all. Each retiree’s situation is different, and developing a sound strategy for your situation is paramount.