Maximizing Your Employee Benefits: 5 Key Options
In the tech industry, compensation packages can be complex. In addition to your salary, you likely have several other valuable benefits. Understanding these benefits is key to maximizing your wealth.
This guide will walk you through each benefit so you can make sure you’re making the most of your compensation package.
5 Key Employee Benefits in the Tech Industry
Before diving into the specifics, here’s a quick overview of the five essential components of your tech compensation package.
1. Restricted Stock Units (RSUs)
RSUs are company shares granted to an employee, which vest over time. Once they vest, they are treated as ordinary income.
2. Employee Stock Purchase Plan (ESPP):
ESPPs allow employees to purchase company stock at a discount, typically through deductions from your payroll.
3. Stock Options
Stock options give employees the right to buy company shares at a predetermined price, known as the strike price, at a future date.
4. Mega Backdoor Roth 401(k):
This benefit allows employees to make after-tax contributions to their 401(k) and then roll those contributions into a Roth IRA, letting you save big on your taxes.
5. Deferred Compensation
Deferred compensation plans let you delay receiving a portion of your income until a future date, potentially reducing your taxes for this year.
Now let’s take a closer look at each!
1. Restricted Stock Units (RSUs)
Restricted Stock Units (RSUs) are a form of equity compensation that many tech companies offer. Unlike stock options, which provide the right to purchase company stock at a set price, RSUs are a promise to issue shares of stock at a future date. This is typically based on the employee's continued service with the company over a specified period.
How RSUs Work
Grant date: This is when the company commits to giving you a certain number of shares, which are “restricted” until they vest. No income or tax is recognized at this stage.
Vesting schedule: RSUs usually vest over a period of years, often following a graded or cliff schedule. For example, a common vesting schedule might be 25% of the shares vesting each year over four years.
Graded vesting: Shares vest incrementally over several years. For example, 25% of the RSUs might vest each year.
Cliff vesting: All the shares vest at once after a certain period, such as all shares vesting after three years.
How RSUs Are Taxed
At vesting: When RSUs vest, the value of the shares becomes taxable as ordinary income based on the fair market value of the shares at the time of vesting. The company will often withhold a portion of the shares to cover the tax obligation.
After vesting: Once vested, you own the shares outright. If you choose to hold onto them, any future gains (or losses) from selling these shares will be taxed as capital gains (or losses).
Tax implications: It's crucial to plan for the tax impact when RSUs vest. Because they are taxed as ordinary income at vesting, a large vesting event could push you into a higher tax bracket. Additionally, if your employer doesn’t withhold enough to cover taxes, you may need to make estimated tax payments.
Incorporating RSUs into Your Investment Strategy
Diversification: RSUs can become a significant part of your overall compensation, but holding too much of your wealth in company stock can increase the risk of your investments. Diversifying by selling vested shares and reinvesting in a broader portfolio can mitigate this risk.
Holding vs. selling: Deciding whether to hold or sell your vested shares depends on your financial goals, risk tolerance, and view of the company’s future performance. If you believe strongly in the company’s prospects, you might choose to hold the shares, but keep in mind the importance of managing risk.
PRO TIP: Consider selling at least a portion of your vested shares to avoid overconcentration in your employer’s stock. This strategy can help you manage risk and ensure that your financial well-being is not overly dependent on the success of a single company.
RSU FAQs
What happens if I leave my company before my RSUs fully vest?
Typically, you forfeit any unvested RSUs. However, some companies may offer accelerated vesting in cases of retirement, disability, or other specific conditions.
How are RSUs taxed?
RSUs are taxed as ordinary income at the time they vest. If you sell the shares after they vest, any additional gains will be taxed as capital gains.
Should I hold or sell my RSUs once they vest?
This depends on your financial goals and risk tolerance. Selling at least some shares to diversify your investments is often a prudent strategy.
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2. Employee Stock Purchase Plan (ESPP)
An Employee Stock Purchase Plan (ESPP) is a company-sponsored program that allows employees to purchase company stock at a discount, often up to 15%. This discount is applied to the stock's fair market value, either at the beginning or the end of a designated purchase period, depending on the plan's structure. ESPPs are typically funded through payroll deductions, making it easy for employees to participate.
How ESPPs Work
Enrollment period: During the enrollment period, employees choose to participate in the ESPP and decide what percentage of their salary they want to contribute, up to a specified limit.
Purchase period: The purchase period is the timeframe during which the contributions accumulate. At the end of this period, the accumulated funds are used to purchase company stock at a discounted price.
Lookback provision: Many ESPPs include a lookback provision, which allows employees to purchase stock at the lower of either the price at the beginning of the purchase period or the price at the end. This feature maximizes the discount and potential gains.
Taxation of ESPPs
Qualifying disposition: If the shares are held for at least two years from the grant date and one year from the purchase date, any gain is taxed as long-term capital gains, and the discount received on the stock is taxed as ordinary income.
Disqualifying disposition: If the shares are sold before meeting these holding requirements, the entire discount at the time of purchase is taxed as ordinary income, with any additional gain taxed as short-term or long-term capital gains, depending on the holding period after purchase.
Incorporating ESPPs into Your Financial Strategy
Immediate sale: Many employees opt for an immediate sale of their ESPP shares after purchase to lock in the discount and avoid the risk of a potential decline in the stock price. This strategy provides a quick profit and eliminates market risk.
Holding for long-term gains: If you believe in your company’s long-term growth, you might consider holding the shares to benefit from potential appreciation. However, this approach carries the risk of stock price volatility, and the tax benefits of a qualifying disposition should be weighed against the risks.
PRO TIP: Always monitor your company's stock performance and your overall portfolio to ensure that you’re not overly exposed to a single stock, even if it's your employer’s.
ESPP Do’s and Don’ts
DO participate in the ESPP if your company offers one, as the discount is essentially free money.
DO consider selling the shares immediately after purchase to lock in gains and minimize risk.
DON’T hold onto ESPP shares solely in hopes of higher future gains without considering the associated risks, especially if your portfolio is already heavily weighted in company stock.
ESPP FAQs
What is a lookback period in an ESPP?
A lookback period allows you to purchase stock at a lower price between the start or end of the offering period, maximizing your potential discount.
What’s the difference between a qualifying and disqualifying disposition?
A qualifying disposition occurs when you hold your ESPP shares for at least two years from the grant date and one year from the purchase date, leading to favorable tax treatment. A disqualifying disposition occurs if you sell the shares before these holding periods are met, resulting in ordinary income tax on the discount.
Should I sell my ESPP shares immediately after purchase?
Many financial advisors recommend selling ESPP shares immediately to lock in the discount and avoid the risk of a potential decline in stock price.
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3. Stock Options
Stock options are a type of equity compensation that gives you the right, but not the obligation, to purchase shares of your company’s stock at a predetermined price, known as the strike price or exercise price. The primary benefit of stock options is the potential for financial gain if the company’s stock price increases above the strike price.
How Stock Options Work
Grant date: The date on which the company grants you the stock options. At this point, you are given the right to purchase a specific number of shares at the strike price.
Vesting schedule: Similar to RSUs, stock options often come with a vesting schedule. You can only exercise your options once they vest. The vesting schedule might be graded (e.g., 25% vest each year over four years) or cliff (e.g., 100% vest after three years).
Exercise period: After your stock options vest, you have the right to exercise them, meaning you can purchase the stock at the strike price. However, you typically have a limited period to exercise the options before they expire, often 10 years from the grant date.
Expiration date: If you do not exercise your options before the expiration date, they lose all value.
Exercising Stock Options
Exercise and hold: You purchase the shares at the strike price and hold onto them. This strategy is typically used if you expect the stock price to continue rising or want to defer the tax impact.
Exercise and sell (cashless exercise): You exercise the options and simultaneously sell the shares. The proceeds from the sale are used to cover the cost of exercising the options, and any remaining amount is your profit. This is a common strategy to avoid paying out-of-pocket to exercise the options.
Tax Implications of Stock Options
Incentive Stock Options (ISOs): If you meet the holding requirements (at least two years from the grant date and one year from the exercise date), the profit from exercising ISOs is taxed as long-term capital gains. If these conditions are not met, the profit is taxed as ordinary income.
Non-Qualified Stock Options (NQSOs): The difference between the market price at exercise and the strike price is taxed as ordinary income. Any additional gain upon selling the stock is taxed as capital gains (short-term or long-term, depending on the holding period).
Incorporating Stock Options into Your Financial Strategy
Evaluate the timing: The timing of exercising your options can have significant tax implications. Consider exercising options in a year when your income is lower to potentially reduce the tax burden.
Consider market conditions: Market conditions can significantly impact the value of your options. If the stock price is volatile, it might be wise to monitor the market closely before deciding to exercise.
Diversify: Like other forms of equity compensation, holding too many stock options can lead to concentration risk. It’s important to diversify your investments to protect against potential downside risks.
PRO TIP: If you are granted both ISOs and NQSOs, you may want to prioritize exercising ISOs for their favorable tax treatment, especially if you believe the stock price will increase significantly. Always consult with a financial advisor to determine the best strategy for exercising your options based on your individual circumstances.
Do’s and Don’ts
DO understand the differences between ISOs and NQSOs and how they are taxed.
DO consider the timing of your exercise to minimize taxes and maximize gains.
DON’T wait too long to exercise options, especially if they are “in-the-money,” to avoid losing their value due to expiration.
Stock Option FAQs
What’s the difference between ISOs and NQSOs?
Incentive Stock Options (ISOs) offer favorable tax treatment, allowing potential capital gains taxes if specific holding requirements are met. Non-qualified Stock Options (NQSOs) are taxed as ordinary income when exercised, with any further gains taxed as capital gains when sold.
What is a cashless exercise?
A cashless exercise allows you to exercise your stock options without paying upfront for the shares. Instead, a portion of the shares is sold to cover the exercise cost, and you receive the remaining shares or cash.
Should I exercise my stock options as soon as they vest?
It depends on your financial situation, the market price of the stock, and tax implications. Consulting with a financial advisor is recommended to determine the best strategy for exercising your options.
4. Mega Backdoor Roth 401(k)
A Mega Backdoor Roth 401(k) is an advanced retirement savings strategy that allows high-income earners to maximize their tax-advantaged savings. This strategy involves making after-tax contributions to your 401(k) plan, which can then be rolled into a Roth IRA or Roth 401(k), where the funds can grow tax-free.
How the Mega Backdoor Roth 401(k) Works
Contribution limits: The IRS sets a contribution limit for 401(k) plans, which includes employee contributions, employer matching contributions, and after-tax contributions. For 2024, this limit is $69,000 (or $76,500 if you’re over 50). The Mega Backdoor Roth strategy allows you to contribute after-tax dollars up to this limit.
After-tax contributions: After maximizing your pre-tax and Roth 401(k) contributions, any additional contributions can be made on an after-tax basis. These contributions can then be rolled over into a Roth IRA or Roth 401(k).
In-service rollovers: Not all 401(k) plans allow in-service rollovers, which are required to implement the Mega Backdoor Roth strategy. If your plan does allow it, you can roll over your after-tax contributions into a Roth IRA or Roth 401(k), where they can grow tax-free.
Tax Advantages of the Mega Backdoor Roth 401(k)
Tax-free growth: Once rolled into a Roth IRA or Roth 401(k), your after-tax contributions grow tax-free, and qualified withdrawals in retirement are also tax-free.
Higher contribution limits: The Mega Backdoor Roth 401(k) allows you to contribute significantly more than the standard Roth IRA limit, which is $7,000 for those under 50 in 2024. This makes it a powerful tool for high earners who want to maximize their retirement savings.
Incorporating the Mega Backdoor Roth 401(k) into Your Financial Strategy
Maximize contributions: To take full advantage of this strategy, aim to maximize your total 401(k) contributions, including after-tax contributions. This requires careful cash flow planning to ensure you can afford these higher contributions without impacting your lifestyle.
Coordinate with equity compensation: If you receive equity compensation, such as RSUs or stock options, consider using the proceeds from selling vested shares to fund your after-tax 401(k) contributions. This can help you take full advantage of the Mega Backdoor Roth strategy without straining your cash flow.
Consult with a financial advisor: The Mega Backdoor Roth 401(k) is a complex strategy with specific rules and potential pitfalls. It’s essential to work with a financial advisor to ensure you’re implementing the strategy correctly and to maximize the benefits.
PRO TIP: Ensure that your 401(k) plan allows for both after-tax contributions and in-service rollovers before pursuing a Mega Backdoor Roth strategy. Not all plans offer these features, and you’ll need both to make this strategy work.
Do’s and Don’ts
DO check if your 401(k) plan allows after-tax contributions and in-service rollovers.
DO plan your cash flow carefully to maximize after-tax contributions without affecting your lifestyle.
DON’T overlook the potential tax benefits of the Mega Backdoor Roth strategy, especially if you’re a high earner.
Mega Backdoor Roth 401(k) FAQs
What are the contribution limits for a Mega Backdoor Roth 401(k)?
The total contribution limit for 401(k) plans, including employer contributions, is $66,000 in 2024 (or $73,500 if you’re over 50). The Mega Backdoor Roth allows you to contribute the difference between this limit and your regular 401(k) contributions.
Can I contribute to both a regular Roth IRA and a Mega Backdoor Roth 401(k)?
Yes, you can contribute to both as long as you stay within the IRS contribution limits for each account. The Mega Backdoor Roth 401(k) is a separate strategy that allows for much higher contributions compared to a standard Roth IRA.
Is the Mega Backdoor Roth 401(k) available to everyone?
No, it depends on whether your employer’s 401(k) plan allows after-tax contributions and in-service rollovers. Not all plans offer these features, so it’s important to check with your plan administrator.
What happens if I max out my 401(k) contributions?
If you max out your traditional 401(k) contributions (pre-tax and Roth contributions), you can still make after-tax contributions up to the IRS limit for total contributions, which can then be converted to a Roth account using the Mega Backdoor Roth strategy.
Can I access the funds in my Mega Backdoor Roth 401(k) before retirement?
Once the funds are rolled into a Roth IRA, you can access your contributions at any time without penalties or taxes, but earnings are subject to Roth IRA withdrawal rules. If the funds are rolled into a Roth 401(k), withdrawal rules specific to the 401(k) plan would apply.
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5. Deferred Compensation
Deferred compensation is an arrangement in which a portion of an employee’s income is paid out at a later date after it has been earned. This is typically done to reduce the immediate tax burden on the employee, as taxes are only paid when the compensation is received. Deferred compensation plans are commonly used by high-income earners and executives to manage their taxable income and plan for retirement.
Types of Deferred Compensation Plans
Non-Qualified Deferred Compensation (NQDC) Plans: These plans allow employees to defer a portion of their income until a later date, such as retirement. Unlike qualified plans (like 401(k)s), NQDC plans do not have contribution limits imposed by the IRS, but they also do not offer the same protections under ERISA (Employee Retirement Income Security Act). NQDC plans are often offered to key executives and highly compensated employees.
Qualified Deferred Compensation Plans: These include traditional retirement plans like 401(k)s and 403(b)s. Contributions to these plans are made with pre-tax dollars, and the earnings grow tax-deferred until retirement.
Risks and Rewards of Deferred Compensation
Tax deferral: The primary benefit of deferred compensation is the ability to defer taxes on a portion of your income until you receive the funds. This can be particularly advantageous if you expect to be in a lower tax bracket in retirement.
Investment growth: The deferred amount can be invested, allowing it to grow tax-deferred over time, potentially leading to a larger payout at retirement.
Employer credit risk: One of the key risks associated with NQDC plans is that the deferred compensation is an unsecured liability of your employer. If your employer faces financial difficulties or goes bankrupt, you could lose the deferred compensation.
Incorporating Deferred Compensation into Your Financial Strategy
Evaluate your financial needs: Before electing to defer compensation, consider your current financial situation and cash flow needs. Deferring too much income could leave you short on cash for immediate needs.
Assess employer stability: Since NQDC plans are unsecured, it’s important to consider the financial health and stability of your employer. If your employer is financially strong, the risk is lower, but if there are concerns about the company’s future, you might want to limit the amount you defer.
Coordinate with other retirement plans: Deferred compensation can be a powerful tool when used in conjunction with other retirement savings plans like 401(k)s and IRAs. Ensure that your overall retirement strategy is balanced and that you’re taking advantage of all available tax-advantaged accounts.
PRO TIP: If your employer offers a deferred compensation plan, consider using it to defer income during peak earning years when you’re in a higher tax bracket. However, be mindful of the employer’s financial stability, as your deferred compensation is subject to the company’s ability to pay.
Do’s and Don’ts
DO evaluate the financial stability of your employer before deferring a significant portion of your income.
DO integrate deferred compensation into your overall retirement plan to maximize tax efficiency.
DON’T defer more income than you can afford, as it may limit your cash flow for current expenses.
Deferred Compensation FAQs
What happens to my deferred compensation if my company goes bankrupt?
Deferred compensation is typically considered an unsecured liability, so if your company goes bankrupt, you may lose the deferred amounts. It’s important to assess the financial health of your employer before deferring significant amounts.
Can I change the deferral period once I’ve set it?
Generally, no. Once you elect to defer compensation, the terms are set and cannot be changed without penalty, unless specific provisions in the plan allow for changes under certain conditions.
How does deferred compensation affect my taxes?
Deferred compensation is not taxed until it is received, potentially lowering your tax burden in the current year and deferring the tax liability to a future year, when you may be in a lower tax bracket.
Is deferred compensation protected under ERISA?
No, non-qualified deferred compensation plans (NQDC) are not protected under ERISA. This means the deferred amounts are not guaranteed and are subject to the employer’s financial health.
Use These Tips to Maximize Your Employee Benefits!
Navigating the complexities of tech compensation can be overwhelming, but with the right planning and expert advice, you can maximize your wealth and secure your financial future. When optimizing your wealth and planning for retirement, taking proactive steps now can make a significant difference in achieving your goals.
At TrueWealth Financial Partners, we are committed to providing personalized guidance tailored to your unique financial situation. Our team of experienced advisors will work closely with you to develop strategies that align with your objectives and help you make the most of your compensation package.
Don’t leave your financial future to chance — take control today. Schedule a quick introductory call with our team, and let’s discuss how we can help you optimize your compensation and achieve your long-term financial goals.
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