The 4 Things People Need to Know About Annual Compensation

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Most people don’t know their exact annual compensation. They know their annual salary or wages, but that’s not the whole picture when it comes to compensation. 

Also called total compensation, annual compensation refers to the total value of a person’s salary and benefits. 

It’s helpful for employees to understand their annual compensation because it shows them the full value of their labor. 

But it’s downright crucial for employers to know the annual compensation for each member of their team. That’s because annual compensation plays a major role in budgeting and hiring. 

There are really only 4 core things that HR teams and employers need to know.

1. What Annual Compensation Is

Annual compensation is the sum total of an employee’s direct and indirect compensation. We’ll talk more about what this means in a moment. 

For now, you can just think of annual compensation as the total amount of money an employee receives:

  • Directly, in the form of a paycheck
  • Indirectly, such as when an employer pays insurance premiums on the employee’s behalf

Annual compensation can look a little different for your salaried employees vs. those on an hourly wage. The cost of PTO is already included in a salaried employee’s annual salary, for example. Not so for hourly employees. 

And keep in mind that annual compensation is different from annual salary. Annual salary refers to all types of direct pay. Annual compensation, on the other hand, encompasses both direct and indirect compensation. 

2. What’s Included in Annual Compensation

Earlier, we said that direct compensation + indirect compensation = annual compensation. 

So what’s behind those two key ingredients? 

Let’s take a look. 

Direct Compensation

Direct compensation includes wages or salary plus things like cash bonuses and overtime pay. Basically, it’s a monetary payment that your employees receive in a straightforward way. 

Along with salary, commissions, and bonuses, these items count as direct compensation: 

  • Variable pay
  • Shift differentials
  • Commissions
  • Travel allowances

Sometimes, a type of compensation can fall into both indirect and direct pay. If you could picture a Venn diagram with a bubble each for direct and indirect compensation, retirement contributions would land in the intersection. 

Even though you don’t give employees the contributions for their 401(k) directly, they will receive that money in cash at some point. You could argue that because of this, 401(k) match benefits belong in direct compensation. 

On the other hand, the money doesn’t go straight to the employee when you pay it to the 401(k) plan. It’s not straightforward compensation. That’s why we usually include it in the indirect compensation category. 

Indirect Compensation

Indirect compensation covers the non-cash benefits employees get. From health insurance and 401(k) matching plans to paid time off (PTO) and childcare help, indirect compensation isn’t as exciting as cash. 

But it does provide a ton of value to employees. And employers have to pay a pretty penny to provide these benefits. 

Here’s a list of things that count as indirect compensation: 

  • Health, vision, and dental insurance
  • Life insurance
  • Disability insurance
  • Unemployment insurance
  • Social Security tax
  • Childcare assistance
  • Professional development assistance
  • Paid time off (PTO)
  • Paid leave for illness, bereavement, parenthood, or jury duty
  • Free or discounted meals
  • Parking discounts
  • Fertility assistance
  • Gym membership
  • Tuition assistance
  • Equity packages
  • Company car
  • Company laptop or phone

You get the idea. 

Every single item on this list costs an employer money to provide. This doesn’t mean you should shove that fact in your employees’ faces and lower their annual salary, of course. Employees care the most about the pay they get to take home. 

But benefits—especially when it comes to healthcare, paid leave, retirement, and PTO—are part of the annual compensation too. 

3. How to Calculate Annual Compensation

To calculate an employee’s annual compensation, write down all the forms of compensation that person receives. For direct compensation, you’ll include the dollar value. Do the same thing for the indirect compensation that you can measure in a dollar amount. 

We’ll show you two examples of this: one for a worker who earns an hourly wage and another for a salaried employee. 

Here’s what annual compensation for one fiscal year might look like for an employee who receives an hourly wage: 

  • Wages: $37 an hour with a 40-hour workweek for a total of $76,960 a year
  • Bonuses: $1,500 bonus in December
  • Overtime pay: Rate for overtime is 1.5 x $37 = $55.5 an hour and the employee worked 50 hours of overtime, for a total of $2,775 in annual overtime pay
  • Health insurance: 85% of a $30,000 healthcare premium for the employee and their family, totalling $25,500
  • 401(k) match: $30,000 in annual contributions 
  • Life insurance: $1,800 in yearly premiums
  • Vision and dental insurance: $240 in yearly premiums
  • PTO: 15 days of PTO per year for a total of $4,440
  • Paid holidays: 11 paid federal holidays for a total of $3,256

The total annual compensation for this employee would be $146,471.

Annual compensation looks a little different for salaried employees because there’s no overtime, and things like paid holidays and PTO are already included in the salary. 

Here’s an example: 

  • Annual salary: $85,000 a year
  • Bonuses: $2,000 bonus every December plus one, $2,000 performance bonus in July 
  • Health insurance: 80% of a $30,000 healthcare premium for the employee and their family, totalling $24,000
  • 401(k) match: $30,000 in annual contributions
  • Life insurance: $2,000 in yearly premiums
  • Vision and dental insurance: $240 in yearly premiums
  • PTO: 15 days off and the cost is included in the salary 

Total annual compensation: $145,240

Remember how I said the term annual salary often gets confused with annual compensation? These examples show us how the annual salary is just one piece of a compensation package. 

And for salaried employees, the annual pay is easy to figure out. Things can get tricky when you employ people on an hourly basis. You’ll have to comb through all the pay stubs for the year and add up the hourly pay, overtime, and pay differentials. 

If you were the business manager for a small hospital, you’d need to sort out the shift differentials and overtime pay that medical professionals often get on top of their hourly wages.

It’s also tough to pin down the value of non-cash benefits. Take PTO for salaried employees, for example. The employee still enjoys vacation time, but the price you pay as an employer is already part of their salary. So you can’t list it again. 

Instead, you can make a note of the non-monetary benefit on a total compensation statement and just leave it at that. It’s still part of an employee’s annual compensation—even if it can’t be represented in numbers. 

4. How Annual Compensation Affects Retirement Plan Contribution Limits 

The most popular type of employer-sponsored retirement plan is a 401(k). But the IRS puts  limits on contributions based on a person’s annual compensation.

Each year, the IRS publishes a limit to the compensation that’s eligible for 401(k) contributions. It’s different every year due to inflation and the rising cost of living. In 2022, the limit was $305,000. 

In 2023, it’s $330,000. 

So what does this mean? 

Let’s say an employee earns $600,000 a year. Their company provides a 401(k) plan wherein 100% of employee deferrals are matched up to a limit of 5% of the employee’s compensation. 

Instead of counting the entire, $600,000 compensation—which would give the employer a limit of $30,000 since that’s 5% of $600,000—only $330,000 of the annual compensation can be counted. 

This keeps the employer match to a limit of $16,500, which is 5% of $330,000. 
Importantly, the IRS is talking about your annual salary plus any additional cash compensation, such as bonuses, commissions, and variable pay. Think of it this way: the $330,000 limit applies to all direct annual compensation only.

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