Your Executive Compensation Package Defined & How it Affects Your Taxes
By The CFP® Team at Washington Wealth Advisors
Understanding and maximizing your compensation package can be a tricky task to navigate, especially when taxes come into play. If you are a highly-compensated employee with a complicated benefit structure, you may have a complex tax return. Don’t let tax season catch you off-guard. Use this guide to understand the different tax implications of your benefits and what you can do to minimize your liability. We recognize this is a dense overview, but we are focused on keeping our clients informed and financially organized.
Base compensation is the first component of your compensation package. It consists of your annual salary and is subject to payroll taxes - Social Security and Medicare – as well as state and federal income tax.
The amount you owe in tax is dependent on your filing status, marginal tax rate, and tax bracket. Since the U.S. tax system is progressive in nature, the more you earn, the more you will owe in tax.
A bonus is a supplemental form of income usually tied to performance, length of service, or company profits. Higher-earning employees may receive a bonus between 5%-11% of their base compensation, which can be a sizable amount for executives and other key employees.
Bonuses help employees feel valued and appreciated. It can be great to receive a large lump sum, but keep in mind that bonuses do not receive favorable tax treatment. Instead, they are taxed at a federal rate of 22% for the first $1 million received, and then 37% for every dollar above $1 million. A $500,000 bonus will be subject to $110,000 in federal income tax alone! That’s before accounting for any applicable state income taxes. As such, bonuses are not the most tax-efficient way to receive compensation, especially as an executive.
Non-Qualified Deferred Compensation
Deferred compensation allows a portion of current earnings to be delayed until a later date (typically retirement) in order to avoid taxation in the current year. Also known as non-qualified plans, there are no contribution limits on how much you can defer. This makes them especially attractive to executives and high-earning employees, particularly if they anticipate being in a lower tax bracket in retirement.
Keep in mind that while you are receiving tax deferral through this benefit, there is no guarantee that you will actually receive these funds. Your employer is not legally obligated to keep pay this compensation in the future and may be unable to do so if they experience financial instability or bankruptcy. When thinking about deferred compensation, be sure to assess your company’s viability and how it could affect your compensation in the future.
401(k) Matching Program
Contributing to a 401(k) is a great way to save for retirement while also saving on taxes. Employees can contribute up to $20,500 per year, and employers will often match 50% on contributions up to 6% of an employee’s salary. This is basically “free” money as long as you meet the minimum contribution needed to get the full employer match. Combining employee contributions with employer-matching is a tax-efficient way to build significant retirement savings. It’s important to note that employer-matching contributions are often not immediately vested, meaning you will have to meet certain requirements regarding length of service before the funds are officially yours to keep.
A nonelective contribution is another type of employer contribution that can be made to your retirement account regardless of whether you contributed to the plan yourself. These contributions come directly from the employer and are not withheld from the employee’s salary. The total combined employee and employer contribution limit for 2022 is $61,000.
Like 401(k) matching, these contributions are often not immediately vested, so this is an important point to consider if you plan on leaving your current employer before the vesting schedule is up.
Restricted Stock Units (RSU)
RSUs are a form of equity compensation that is subject to a vesting schedule. Employers will promise shares of company stock to employees that they will earn over time by reaching certain performance milestones or years of service to the company. Once an RSU has become fully vested, it is converted to stock.
At this point, the fair market value of the converted shares is considered compensation and will be taxed at your marginal tax rate, just like additional salary. Understanding when this will happen is crucial in order to minimize your tax liability. For instance, if you expect a large portion of your RSUs to vest next year, you should try to minimize or defer other income to a different year, so you aren’t pushed into the next tax bracket.
It’s also important to think through what you want to do with the stock once it has become available. RSUs are simply salary delivered as stock options – therefore, many employees choose to sell RUSs immediately upon vesting. On the other hand, selling RSUs within one year of vesting may result in gains that will be taxed as ordinary income, whereas holding it for at least a year will allow any gain to be taxed at the preferential, long-term capital gains rate. Either way, fully integrating your RSUs into your wealth management plan is a necessary step – your advisor can help you determine the best time to sell.
An ESPP is another form of equity compensation in which your employer allows you to purchase company stock, usually at a discounted price. Your employer will make it easy for you by automatically and regularly withdrawing money from your paycheck to finance your purchases of company stock.
During the offering period of your ESPP, after-tax payroll deductions are accumulated. Then, during the purchase period, those deductions are used to effectively purchase company stock at a discount of 15% or less. During a given year, the maximum amount of capital an employee can invest in their company stock through their ESPP is capped at $25,000.
To preserve favorable tax treatment, you must refrain from selling the stock for at least 2 years from the start of the offering period, and 1 year from the date in which the shares were purchased. If these conditions are not met, a portion of the gain will be taxed as ordinary income at your marginal tax rate.
ESOs are a third type of equity compensation in which an employee is given the right to purchase shares of the company’s stock at a set price (exercise price) for a set period of time. If the price of the company’s stock rises above the exercise price, a profit can be made by buying stock at the discounted price and then immediately selling it on the market.
If the plan is an incentive stock option (ISO), you will not be taxed until you eventually sell the stock; at which point, if certain holding period requirements are met, the gains are given preferential tax treatment by being taxed as long-term capital gains rather than ordinary income.
To obtain this preferential tax treatment, you must hold the ISO for at least 2 years from the date of grant and 1 year from the date of exercise. If you sell the stock early, a portion of the gain will be taxed as ordinary income. ISOs are very tax-efficient if all requirements are met, but they could cause you to be pushed into the alternative minimum tax (AMT) system if you’re not careful. It is crucial to thoroughly assess the timing when exercising your ISOs so that you don’t mistakenly create a huge tax liability for yourself.
Non-qualified stock options (NQSO), on the other hand, do not receive preferential tax treatment. At the time you exercise the option, you will be taxed on the difference between the fair market value of the stock and discounted purchase price you bought it for. When you sell the stock, it can be taxed as either ordinary income or capital gain depending on how long you keep it before sale.
A profit-sharing contribution is a discretionary addition to your retirement account made by your employer, and it’s usually based on company performance. It is typically a one-time contribution made at the end of the year, similar to a bonus. But unlike a bonus, it is not taxed immediately. Instead, the contribution receives tax deferral until it is withdrawn from the retirement plan in the future.
Health savings accounts (HSA) offer triple tax savings. You can contribute pre-tax dollars, pay no taxes on earnings, and withdraw the money tax-free to pay for medical expenses. Unused funds roll over each year and can be withdrawn without penalty (but taxable) for non-medical expenses at age 65, essentially becoming an IRA. You must be enrolled in a high-deductible health plan in order to qualify for an HAS.
HSAs can be a great tax-management tool, especially if your employer agrees to match your contributions and if you are able to pay medical expenses out of pocket and leave the HSA funds to earn tax-free growth. The 2022 IRS combined contribution limits (employer and employee) are $3,650 for individuals and $7,300 for families.
If reading through all these compensation options has your head swimming, don’t worry! At Washington Wealth Advisors, we have the tools and expertise to help you navigate your compensation package – along with the associated tax implications – with confidence. Some call us their personal CFO. Don’t miss out on the benefits available to you. Call our office at 703.584.2700, email firstname.lastname@example.org, schedule a meeting with us to get started today.
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