You’ve Been Promoted: A Guide to Your Compensation Package
It’s performance assessment season. You’ve earned a well-deserved promotion at work. Hopefully the new job title also comes with more money! I’d like to discuss the four components of your updated compensation package: cash compensation, equity compensation, employee benefits, and taxes.
This includes your base salary and cash bonus. Divide your new base salary by 24 or 26 to calculate your gross paycheck.
If you receive a bonus, have a plan for this lump sum. My clients commonly use their bonus to:
- Pay property tax installment
- Set aside funds for taxes owed April 15th (refer to the tax section below for why you may owe taxes)
- Set aside funds for a short-term goal (e.g., new car; down payment)
- Top up their emergency fund
- Transfer to a brokerage or trust account (i.e., a non-retirement account) for long-term investment
RSUs (Restricted Stock Units)
You’re paid shares of stock with strings attached (vesting schedule). You likely have received a new “refresher” grant of restricted stock units because of your promotion. I discuss RSUs extensively in this blog post.
Performance awards aren’t cash bonuses. They’re equity compensation typically paid to senior employees at mature public companies. Performance awards come in many forms. I’ve mainly seen Performance RSUs. These are RSUs that have two components:
- The usual time-based vesting schedule
- A company performance component. For example, the company must hit a certain EBITDA target for the PRSUs to vest (earnings before interest, taxes, depreciation, and amortization). The number of PRSUs that vest could be higher than the initial grant quantity if your company exceeds its performance target. Or the PRSUs could pay zero if your company misses its performance target.
NSOs (Non-qualified Stock Options)
You have the right to buy company stock at a fixed price (“strike price” or “exercise price”) for a fixed period of time (usually 10 years). They typically are offered at growth-stage private companies (starting at Series B or C financing). I sometimes see NSOs awarded to senior employees at public companies, but RSUs and Performance Awards are far more common.
ISOs (Incentive Stock Options)
Like NSOs, you have the right to buy company stock at a fixed price (“strike price” or “exercise price”) for a fixed period of time (usually 10 years). I don’t see ISOs unless the client is at an early stage startup.
“I review my paycheck on a regular basis,” says no one. It’s understandable: most people just want their direct deposit every two weeks or twice a month. But review your new, bigger paycheck, specifically the deductions for employee benefits. I’ve spotted these issues when reviewing clients’ paychecks:
New clients have often told me that they’re “maxing out” their 401(k). When I review their paycheck, however, they’re contributing just enough to take advantage of the company match. If you can afford it, contribute the maximum to your 401(k): $19,000 in 2019 ($25,000 if you’re 50 and over).
Next, review your contribution type: pre-tax or Roth. Many companies offer two flavors of 401(k) plans: the traditional pre-tax 401(k), or a Roth 401(k). High-income earners are generally better off contributing to a traditional pre-tax 401(k) rather than a Roth 401(k). This is because the greater your income, the higher your income tax bracket, which means contributing to a pre-tax 401(k) would lead to greater tax savings.
Finally, can you contribute more than $19,000 to the 401(k)? Or more than $25,000 if you’re 50 and over? In other words, I work with clients to identify whether their company allows after-tax contributions.
You don’t need to wait until open enrollment to change your 401(k). For the next three benefits, however, you typically must wait until open enrollment to make changes.
I provide an overview about making the most of your 401(k). And you can learn even more about 401(k) plans in my free guide, The Single Professional Woman’s Personal Finance Guide: Common Blind Spots That Could Cost You (Now or Later).
Group Life Insurance
Are you paying for group life insurance that you don’t need? If you don’t have any financial dependents (including pets), the free life insurance through work may be sufficient. Or if you do need life insurance, you may be better off purchasing a policy that’s not tied to your employment. I write about life insurance in this blog post.
HSA and FSA Plans
If you’re not contributing to an HSA (Health Savings Account) or FSA (Flex Spending Account), it may make sense to start during open enrollment. Contributing to either one will save on federal taxes. HSA contributions are taxed by California, however. HSAs are attached to a form of health insurance called High Deductible Health Plans, and the balance rolls over year-to-year. FSAs are use it or lose it.
If you have dependents like minor children or elderly relatives, consider the Dependent Care FSA. If you’re married, coordinate these contributions with your spouse.
I write about HSAs and both types of FSAs in this blog post about open enrollment.
Review your health, dental, and vision insurance situation. If you’re married, should you switch to your spouse’s coverage? Or should each of you individually enroll at your respective companies? If you’re not married but in a committed relationship, can you switch to your partner’s coverage? Should you switch? Some employers like Google offer this benefit to unmarried couples. I write about health insurance in this blog post about open enrollment.
In the US, you must pay income taxes throughout the year. The income taxes are withheld from your paychecks because the IRS and your state tax authority don’t want to wait until next April 15th for their money.
The IRS and the California Franchise Tax Board (FTB) has two sets of rules that determine how much income taxes are withheld from your paycheck:
- Regular wages: your base salary
- Supplemental wages: everything else, including cash bonuses, RSU vesting, and the bargain element (“spread”) from stock option exercises.
It’s important to understand the difference because each is subject to different withholding rules.
Tax withholding on regular wages is based on: (1) a formula defined by the IRS and California FTB, and (2) the numbers you entered on an IRS form called the W-4, and the DE-4 for California. Maybe you haven’t touched these forms since your hire date. A tax-focused financial planner can help you update these forms. You benefit by avoiding a surprise tax bill and potential late payment penalties. Another benefit is avoiding a huge tax refund. I discuss the W-4 and the mechanics of paying taxes in this blog post.
Tax withholding on supplemental wages is based on formulas defined by the IRS and California FTB. Common sources of supplemental wages are your annual bonus, RSU vesting, and stock option exercises.
As of 2019, these are the flat withholding rates on supplemental wages:
- 22% federal (37% on compensation > $1 million)
- 23% state
- 45% Medicare
- 9% Medicare surtax (see next section)
- 2% Social Security*
- 1% California State Disability Insurance**
*Assessed on the first $132,900 of wages in 2019. Any wages in excess of this annual limit aren’t subject to the Social Security tax.
**Assessed on the first $118,371 of wages in 2019. Any wages in excess of this annual limit aren’t subject to the California disability tax.
Companies must withhold the 0.9% Medicare surtax when your wages (e.g., base salary, bonus, income from vested RSUs) exceed $200,000. Unlike Social Security and California State Disability Insurance taxes, Medicare taxes aren’t capped.
Special Note on Estimated Tax Payments
You now know that your company must withhold a flat 22% for federal income tax on supplemental wages (37% if >$1 million). If your taxable income is greater than $83,000 for single filers ($165,000 if married filing jointly), you likely will still owe federal income taxes next April 15th. To avoid tax penalties and/or a giant surprise tax bill next April 15th, you may need to pay estimated taxes. Consult with a financial planner or tax professional to have your individual situation assessed.
For California income tax, your company must withhold a flat 10.23%. For very high earners (>$345K for single filers, $690K for married filing jointly), you likely will still owe state income taxes next April 15th. Again, you may be better off paying California estimated taxes. Consult with a financial planner or tax professional to have your individual situation assessed.
Actions to Take
Consider working with a financial planner and/or tax professional to run a forward-looking tax projection. This will help clarify the tax impact of your new, higher compensation. You’ll also learn if you’re withholding enough tax from your paychecks, and whether you should make quarterly estimated tax payments.
Cash Flow Planning
Are your regular paychecks enough to pay your bills? If you max out your ESPP (Employee Stock Purchase Plan), cash flow may feel tight. Are you subject to trading blackout periods where you’re not allowed to sell company stock resulting from the ESPP and RSU vesting? If so, that makes it even tougher to manage cash flow. You’ll need to monitor trading windows, which are defined by your company, to sell company stock.
A 10b5-1 plan may be a potential solution. Does your company offer this to its employees? A 10b5-1 plan is an automated sales plan so that you don’t have to wait until a trading window to log into your stock plan administrator’s website to sell shares.
Non-qualified Deferred Compensation
If you’re a senior employee, your company may offer non-qualified deferred compensation (NQDC) plan. This benefit would allow you to save on income taxes by deferring a much larger portion of your compensation beyond the 401(k) plan. You wouldn’t pay income taxes until the deferred compensation is paid.
A 401(k) plan is a qualified deferred compensation plan. There are countless federal laws governing 401(k) plans, and companies are subject to financial consequences if these plans favor highly compensated employees.
A non-qualified deferred compensation plan, however, is not subject to federal oversight. Companies can restrict NQDC plans to highly compensated employees such as their senior employees. There are many ways to design the payout of an NQDC plan.