The Planner's Perspective: Planning For Variable Income
By Paul Morrone, CFP®, CPA/PFS, MSA
Compensation comes in many forms, but the most common form is cash. Many employees are used to getting an annual salary and a periodic bonus, which makes tax and financial planning easier, at least from a cash flow management standpoint. Those who receive significant bonuses, however, are faced with different challenges as variable compensation (commissions, bonuses, etc.) is generally not guaranteed and can vary greatly from period to period. The ambiguity around the timing and amount of future bonuses, especially for highly compensated employees and executives, creates planning challenges for those who have compensation packages heavily influenced by future unknowns.
For financial planning purposes, we often recommend conservatively estimating the amount of periodic bonuses to create a greater chance of long-term financial plan success as the assumptions used will be based on (hopefully) lower income figures than those actually realized in the future. This also means making regular plan updates based upon known information to ensure that the assumptions being used are as accurate as possible to generate the highest probability of long-term plan success.
Accumulating assets and establishing a systematic savings plan (outside of company retirement plans) for individuals with this type of compensation should be approached differently than those that have a predicable salary/bonus structure each year. This means that periodic contributions may need to be tailored to the amount of a bonus rather than assigning a fixed amount to be saved each period. The timing of savings contributions may also need to coincide with the payment of bonuses as committing to a monthly contribution may not be consistent with how income is earned.
Asset allocation may also need to be adjusted to compensate for the uncertainty of this type of compensation arrangement. To mitigate the risk of needing to liquidate investments to fund short-term cash needs, it may be wise to keep a larger emergency fund to be able to maintain lifestyle expenses when bonuses are smaller than expected. Additionally, a largely liquid investment portfolio will allow an investor to generate cash quickly if emergency fund resources are depleted suddenly and there is an interim cash need. We also recommend that people in this position have access to bridge financing such as home equity lines of credit, securities lines of credit, or other forms of secured financing to help manage cash flow throughout the year. Maintaining liquidity and having quick access to credit (at a favorable rate) preserves an individual’s ability to be nimble and react to unfavorable changes in income, especially if they come unexpectedly.
From a tax standpoint, there are also a few challenges that need to be considered for high earners with a bonus heavy compensation structure. The first is withholding on those payments, which is generally considered ‘supplemental compensation’ in the eyes of the IRS. This means that only a flat 22% be withheld on the gross bonus payment (unless the payment is for over $1.0mm, at which point the required withholding rate is 37%). For high earners, this is often insufficient as tax rates for those over $170k in income can easily exceed the 22% mandatory withholding requirement. As such, it is important to review current and estimated income for the year and manually increase your withholding accordingly to account for the higher marginal tax brackets of 24%, 32% 35% and 37% for taxable income over $170k (married filing jointly).
Variable income also impacts other areas of the tax return, which includes additional taxes on wages and investment income and availability credits and deductions for higher earners. In fact, the impact of this can be so significant, that for tax planning purposes only, it is often a best practice to make aggressive (or best-case scenario) estimates as to what your total income could be for the upcoming year. This will help you determine whether you will be subject to the phaseout of deductions or credits which may adversely affect your tax liability. Doing so will also help you plan for the impact of items such as the 3.8% net investment income tax on passive income which may reduce the after-tax realized value on your portfolio income during the year.
There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.