High Income Taxes—Should You Change Your Compensation Strategy?

Income taxes increased dramatically in 2013 for high income earners. Is there any bright side to higher taxes? No! But let’s talk about how the right compensation strategies can minimize their impact.

Top earners are now in a 39.6% marginal bracket. Add state taxes (for most states)-let's assume 5.05%. (Wouldn't that be nice Californians and New Yorkers?) Then add the Medicare tax on income over $113,700-2.35%. That adds up to a true marginal rate of 47.0% on the top dollars earned by high achievers. Ugh!

Let’s consider some compensation strategies that will help creative employers offer relief to their top earners. There are several, but let's look at two examples for now.

First, revisit deferred compensation plans (DCP). These plans allow high earners to voluntarily defer parts of salary or bonuses and postpone taxes to a future date. Deferring to the future offers several immediate benefits:

  • Reduce taxable income below the new top rate threshold ($400k for single filers; $450k for married/joint filers);
  • Reduce MAGI (modified adjusted gross income) below the Medicare tax threshold ($200k/$250k);
  • Reduce AGI below the threshold where personal exemptions and itemized deductions are phased out ($250k/$300k).

In addition, assuming the same tax rates in the future as today, deferred dollars almost always result in larger after-tax values in the future (given the same growth assumptions inside the DCP as in an outside investment account).

Second, beef up long-term incentives. Employees may be pleased to exchange some of their incremental “53 cents on the dollar compensation” for long-term equity or phantom stock. Or, a smart employer may simply add such a plan to existing promises. Let’s consider phantom stock. Grants received today equal a financial stake in the future company with no current tax! That’s right. You can give me 1%, 5% or 10% of your company “value” through phantom stock and I will incur no taxes today. What happens when the shares are redeemed in the future? Yes, taxes. However, we might be able to move payments into lower tax years, or spread them over time. In other words, we can often find ways to move the reportable income into periods where the employee may fall below the tax maximizing thresholds discussed above.

But here’s my main point: Employers that explore and implement techniques to help high income earners reduce, avoid or delay taxes are offering a benefit that just went up in value thanks to Washington. Don’t let your key employees be lured away because your competitor adopts these ideas before you do.

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