Four strategies to optimize the impact of a significant salary increase.
After years of long hours and late nights, you’ve finally earned a well-deserved promotion and the salary to match. Suddenly, you find that your compensation has increased beyond your expectations, with new income streams that include variable pay and stock-based compensation.
How can you optimize the value of your position and avoid mistakes that can come with a bump in income? Take these smart financial steps after a promotion to make the most of your earnings.
Adjust Your Income Taxes
When you have several different sources of income, it’s important to understand and review strategies to lower your tax liability. Now is an excellent time to review your W-4 to make sure it accurately reflects your current financial and household situation. Doing so will help avoid a hefty bill covering underpayment penalties and interest.
Let’s talk about the variable pay scheduled to hit your account at the end of the month. The IRS considers such funds supplemental income and applies a higher rate than your usual income tax rate. Your employer can withhold taxes from your variable pay using either:
- The aggregate method, in which they add the variable amount to a regular paycheck and withhold more money from that paycheck accordingly.
- The percentage method, in which you receive a separate check taxed at a flat 22 percent up to $1 million.
If your standard tax rate exceeds 22 percent, ask your employer for a separate check if possible. Otherwise, the aggregate method works in your favor.
If you receive equity compensation and work at a publicly traded company, this may take the form of restricted stock units (RSUs). Employers issue these shares on a vesting schedule over time. Pay close attention to this arrangement—when your shares vest, the IRS will tax the value as income. Many companies tend to pay a higher portion of income in the form of RSUs as you move higher up the ranks, making an appropriate withholdings rate more impactful.
If you hold the stock for less than a year before selling, the profit you earn on the transaction is treated as short-term capital gains (or loss) and taxed accordingly. After a year or more, the gain or loss is subject to long-term capital gains rates. These are typically lower, frequently 15 percent for taxpayers who earned $40,401–$445,850 in 2021 and 20 percent for higher-income individuals. Investment income can also be subject to the net investment income tax of 3.8 percent.
You might have other tax planning considerations if you have ascended to a new tax bracket. For example, you might not be able to deduct expenses that used to offset your income. Get advice from a financial advisor to see the big picture.
Look Ahead to Retirement
Based on the above information, you probably have questions about reducing the tax burden associated with your increased income. With after-tax retirement contributions, you can maximize the amount you put away for your future and limit the taxes you pay on your hard-earned dollars.
First, make sure you contribute the maximum to your employer-sponsored retirement plan if you don’t already do so. In 2021, you can stash up to $19,500 in your 401(k) and another $6,000 in an IRA, subject to annual income caps established by the IRS. Once you reach age 50 or older, you qualify for an extra catch-up contribution of $6,500 to your 401(k) and an additional $1,000 contribution to your traditional or Roth IRA in 2021.
Ready for the big leagues? See if you qualify for a mega backdoor Roth IRA strategy, which requires you to have a 401(k) plan that allows after-tax contributions and in-plan Roth conversions or in-service withdrawals. If both these factors apply, you can make an after-tax contribution and quickly transfer it to a Roth IRA, thus taking advantage of tax-free growth if you play your cards right.
Partner With a Financial Advisor
When is it time to partner with a trusted financial advisor? Kiplinger recommends seeking professional support if you have multiple streams of income and/or a complex tax situation, such as the Roth IRA conversion described above.
When you choose a financial advisor, they may have certification from the National Certified Financial Planner Board of Standards. CFPs must complete rigorous exams and take a holistic approach to integrate the various aspects of your financial life. These professionals also agree to act in a fiduciary capacity for their clients, which means they have committed to serving your best financial interests.
Once you have a shortlist of candidates, find the right fit for your finances by asking questions such as:
- What is included in your scope of services? Are there benefits you offer in addition to investment advice?
- What is your investment philosophy and approach?
- Do you work with other clients like me? Do you have expertise or experience with the company I work for?
- Are there any commissions or fees on the funds you recommend?
Avoid Lifestyle Inflation
While it’s easier said than done, resist the temptation to make major upgrades to match your larger bank account. If you’re dreaming of a vacation home, property renovations, or other large purchases, press the pause button before you sign on the dotted line. Instead, practice socking away your additional income for a few months and keep living on your former salary.
With this guide, you can set the stage to elevate your financial future with the preparation to achieve the short-term, mid-term, and long-term financial goals that reflect your big-picture objectives.
Zach Smith, CFP® serves as an advisor in Brighton Jones’ Palo Alto office.
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