How to understand and evaluate total compensation packages
The competition among companies for talented tech professionals is often fierce. A 2024 survey from World at Work revealed over a third of tech companies find it difficult to hire qualified candidates for open positionsWorld at Work: <a href="https://worldatwork.org/publications/workspan-daily/what-buttons-are-tech-companies-pushing-to-maximize-their-pay-programs-" aria-label="">What Buttons Are Tech Companies Pushing to Maximize Their Pay Programs?</a> May 2024 . To attract and motivate top talent, many innovative companies offer various types of compensation and incentives that go beyond just a great salary. Consequently, your next job offer or comp package might include a list of unfamiliar terms and confusing acronyms that make it difficult to evaluate and compare with others.
Fear not, in this article, we will explore several prominent types of alternative compensation, decipher the alphabet soup of acronyms and investigate some key considerations to help you better understand what’s being offered in a total compensation package. And while medical insurance, retirement benefit plans, flexible work options, education reimbursement, and other non-cash employment perks can add substantial value to a job, we’ll keep this focused on exploring additional types of monetary compensation.
Why companies offer alternative compensation
Tech research firm Gartner found that IT employees expected merit pay increases of 7% or more from their current employers and around an 11% pay bump if they switched to a new employerGartner: <a href="https://www.gartner.com/en/documents/5123531" aria-label="">Tech CEOs: 3 Compensation Strategies to Combat Salary Inflation</a>, Jan. 2024 .
"Tech employees expected 7% or higher merit pay increases in 2024."
– GartnerGartner: <a href="https://www.gartner.com/en/documents/5123531" aria-label="">Tech CEOs: 3 Compensation Strategies to Combat Salary Inflation</a>, Jan. 2024
Instead of continuously raising salaries to attract and retain employees, offering alternative compensation types, such as stock options or performance bonuses, allows companies to reduce their immediate payroll expenses while still providing compelling reasons to join, start with, and work hard for the company.
Equity compensation
Since the early days of tech, offering employees the opportunity to gain partial ownership (AKA equity) in the companies they help to build has fueled the growth of the industry. Equity compensation generally falls into two categories: stock options and stock units.
Exploring your options
Stock options grant you the right (but not the obligation) to purchase a specified number of shares of company stock at a predetermined strike price. This means you could potentially buy shares at a price below the current stock market price and instantly increase your net worth. Of course, anywhere there are gains, there are tax implications, and a significant difference between types of stock options is how they are treated by the IRS.
Two types of stock options you might come across are Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs). How each works and how they are taxed depends on a range of factors, including when the option is exercised, the fair market value (FMV) of shares, and how long shares are held before being sold. Here’s a breakdown of some of the differences as of 2024:
Incentive stock options (ISOs)
- Eligibility: Only employees can receive ISOs. Non-employee advisors, directors, and consultants are not eligible.
- Taxation at grant of option: None.
- Taxation at exercise of option: Generally, not an ordinary income tax event, but you could be subject to alternative minimum tax (AMT).
- Taxation at sale of shares: The difference between the strike price and sale price is taxed at long-term or short-term capital gains rate depending on how long you hold the shares.
- Holding period: For the best long-term capital gains tax treatment, you need to hold shares for at least two years after the date the ISO was granted and for at least one year after exercising the option.
- Other considerations: Options must be exercised within three months of employment termination (longer in cases of death or disability). Limits to timing and value of options that can be exercised per calendar year. ISOs expire within a maximum of 10 years.
Non-qualified stock options (NSOs):
- Eligibility: Directors, consultants, advisors, employees and other service providers can receive NSOs.
- Taxation at grant of option: None.
- Taxation at exercise of option: The spread between strike price and fair market value (FMV) is taxed as regular income.
- Taxation at sale of shares: The difference between the FMV at exercise and sale price may be taxed at long-term or short-term capital gains rate depending on how long you hold the shares.
- Holding period: For optimal long-term capital gains tax treatment, you need to hold the shares for at least one year after exercising the option.
- Other considerations: Option expiration and termination provisions set by the NSO plan/agreement.
In short, ISOs offer more potential tax benefits but have extra restrictions and requirements. NSOs are more flexible but could incur more taxes. Whichever type of stock option you’re offered, it can be a tremendous opportunity to build wealth. However, to avoid significant pitfalls, it’s crucial to also be smart about the timing and details for when you exercise your options or sell any shares. Consult your financial advisor and/or CPA to help you evaluate job offers and pay packets that include stock options and to strategize how to use them to your greatest advantage.
ISOs typically offer more tax benefits than NS0s but have additional restriction and requirements.
The direct approach: stock units
There are also a variety of ways that companies grant stock units directly to employees. These approaches typically involve vesting schedules and cliffs designed to motivate and keep people over the longer time periods. Some terms and acronyms you might encounter in a total compensation package include:
Restricted Stock Units (RSUs): A grant of number of shares that vest over time based on length of employment or other conditions.
Restricted Stock Awards (RSAs): Similar to RSUs, but shares are granted outright and subject to forfeiture if vesting timeframes or performance conditions aren’t met.
Deferred Stock Units (DSUs): A form of deferred compensation that vests and settles shares at a point in the future such as upon retirement or termination of employment.
Performance Stock Units (PSUs): Type of RSUs with vesting and details tied to achieving defined performance metrics.
While the nuances between these types of equity compensation may seem minor, there can be significant differences in how they could impact your annual taxable income and tax obligations. Again, consulting your financial advisor and/or CPA will help you maximize the benefits and avoid missed opportunities with stock unit grants.
Income boosters: bonuses
With their straightforward names and lack of acronyms, bonuses are the easiest type of alternative compensation to understand. They typically fall into one of two camps:
Performance bonuses: Additional cash compensation given to employees based on job performance, length of employment, or achievement of specific goals. Conditions, vesting schedules, metrics, milestones and bonus amounts will vary.
Signing/sign-on bonuses: Up-front or time-bound payments to entice new employees to accept a job offer. Often negotiable, the amount of the bonus can vary based on the level of a position and how highly sought-after a person’s skills and experience are.
In most cases, the IRS views bonuses as supplemental wages, and employers will use either the percentage or aggerate method to determine required income tax withholding<a href="https://www.irs.gov/publications/p15a" aria-label="">IRS Publication 15-A (2024), Employer's Supplemental Tax Guide</a> . Of course, your financial advisor, CPA or tax professional can help you better understand the tax implications that a particular bonus might create with your unique situation.
Closing thoughts
Being able to accurately evaluate alternative compensation details is crucial for making informed career decisions. Beyond understanding the terms, it’s also important to factor in the length of vesting schedules as well as the growth potential and stability of the company to accurately gauge the risks and rewards associated with an offer.
Remember, you don’t have to travel this leg of your career journey alone. Your team of professional advisors have the knowledge, experience and strategies to help you maximize the opportunities of alternative compensation and achieve your financial goals.