In a world of ever-increasing ways to incentivize employees, there are various methods for compensating top-level executives for their contributions above and beyond their day-to-day requirements. One thing is for certain, for decades there has been a tried and true way of telling employees that they deserve a little extra—that additional compensation is known as a bonus. We are all familiar with it. In fact, many of us can probably recall the time Clark Griswold in “National Lampoon’s Christmas Vacation” was neglected his annual Christmas bonus, with which he had planned to put in a pool for his family.
The idea of the bonus has been weaved throughout our cultural fabric for years, but there are actually two very distinct and different ways an employer can choose to distribute a bonus to its employees: a cash bonus or a stock bonus. As an executive, you may find yourself making a choice between these two bonus types, especially when joining a new company. That is why it’s important to understand the pros and cons of a cash bonus vs. stock bonus, and how each might best fit your financial situation.
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Benefits and Drawbacks of a Cash Bonus
To start, let’s take a look at the more traditional type of bonus, which is a cash bonus. First of all, it’s important to know how a cash bonus is taxed and viewed by the IRS. If you are paid your bonus as part of your regular wages, not otherwise indicated as a separate bonus payout, it is taxed at your normal income tax bracket through your payroll system.
If your bonus is clearly indicated as a bonus payout and separate from your normal income, your employer has the option to withhold a 22% flat amount or calculate individual withholding amounts based on your normal tax bracket.
Many executives, however, fall into a different category if they are compensated more than $1 million in bonus and other supplemental income sources. Any bonus amount over $1 million is subject to the higher of a 37% tax rate or the highest tax rate in that given year. On the positive side, any amount below $1 million is subject to the taxation mentioned above.
One of the major benefits of a cash bonus, as opposed to a stock bonus, is the avoidance of stock market risk that you incur when being compensated with company stock. This risk is also compounded if you already own a concentrated equity position of your employer’s stock.
On the contrary, a cash bonus does not give you the upside potential to generate wealth that the stock bonus offers. When considering a cash bonus vs. a stock bonus, you need to consider both the upside and the downside of potential returns. An experienced executive financial advisor can quantify this for you by weighing the risks and the rewards.
Advantages and Disadvantages of a Stock Bonus
Now that we understand how a cash bonus is taxed, let’s take a look at the taxable incident a stock bonus can cause. The most common form of a stock bonus is a restricted stock unit (RSU). These are popular because many employers allow for the option to receive the stock units as shares of company stock or as a cash equivalent. If you choose to take the company stock option rather than the cash, you can expect to pay your normal income tax rate when the stock units become fully vested. Many employers will give you the option to withhold a certain number of shares to pay for the income tax due, and some even automate the process for you.
The variability comes when you choose to sell the shares of stock. If you sell the stock within the first year of vesting, you will pay a short-term capital gains tax rate. If you can wait longer than a year after the stock units are vested, then you can expect to pay a long-term capital gains tax rate, which is more favorable.
You also have the option, when the stock units are granted, to file an 83(b) election, which allows you to pay income tax on the market value of the stock when it is granted rather than waiting three years for it to vest. The major benefit enjoyed here is if the stock price rises within that time frame, you will have paid less in taxes up front than you would have if you waited until the price was up and the units were fully vested.
The major benefit of opting for the stock bonus vs. the cash bonus is that you get the chance to enjoy an increase in stock price over the next three years or so. Essentially, it gives your bonus the ability to grow over time as you wait until it is fully vested. The downside to this strategy is that you are exposed to market risk and could have potentially been paid more up front in a cash bonus if the share price drops.
Cash Bonus vs. Stock Bonus: Making a Decision
When you are faced with the decision of taking a cash bonus vs. a stock bonus, it is important to consult with a financial advisor who has experience in helping top-level executives make that very same decision. An advisor’s expertise can guide you in exploring the pros and cons of each type and quantify what the risks vs. rewards look like in the context of your financial portfolio. When it comes to making executive compensation options, a trusted advisor is irreplaceable in the decision-making process.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist in equity compensation planning.
As experts in executive-level equity compensation planning, the Carpenter Team can advise you on the pros and cons of a cash bonus vs. stock bonus, and much more. Schedule an in-person or online meeting today.