It might have been a hard year, but if you’re lucky enough, you might still find a little year-end bonus in December’s paycheck. Before you get too excited, though, don’t forget the lesson learned from that holiday classic Christmas Vacation.
“Don’t spend it before it has been paid,” says Steve Parrish, Co-Director of the Center for Retirement Income at The American College of Financial Services in King of Prussia, Pennsylvania. “Think of Clark Griswold and his ‘jelly of the month’ bonus. Next, pay yourself first, meaning don’t spend the money, but invest it.”
Usually, this means stashing your bonus away so you can enjoy it at some point in your future.
“For employees receiving a year-end bonus, they have access to their retirement plan through work, as well as some other types of savings plans such as employee stock purchase plans as well as deferred compensation plans,” says Jason D. Field, Financial Advisor at Van Leeuwen & Company in Princeton, New Jersey. “One key decision for employees receiving a bonus is whether to contribute to retirement plans with their bonus payout. Most companies will let an employee make an election specific to their bonus when it comes to retirement savings.”
In deciding where to spend your year-end bonus, you should not only think inside the box (i.e., your company plan), but outside the box, too.
“If your employer offers a 401(k), 403(b) or other employer sponsored plan, that is a great benefit to explore,” says Sten Morgan, President of Legacy Investment Planning in Franklin, Tennessee. “Outside of an employer sponsored plan, everyone is eligible to fund some form of IRA, or non-qualified investment or savings account. The more options an investor has the more likely they are to not do anything, so the goal is to make forward progress and do not get paralyzed by looking for the ‘perfect’ option.”
Are you wondering what you should do with your bonus? Here’s a list of ways to spend that money that might benefit you the most. And, yes, some say they’re in the priority you should pay attention to.
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#1: The Company Plan
This is the usual “go-to” destination for bonuses, and for good reason.
“Employees who receive W2 salary, can contribute $19,500 plus $6,500 in an employer sponsored retirement plan,” says Syed Nishat, Partner at Wall Street Alliance Group in New York City. “Retirement plan options may include 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan. One factor to determine with the year-end bonus is whether it’s taxed at a flat 22% because it can be taxed at 37% for high earners if their income is over $1 million. Employees can prefund their retirement plan up to the limit from the bonus funds to lower their overall taxes vs. regular monthly deferrals.”
In determining whether this is the best way for you to go, you need to consider two steps.
Step One: Are you getting all you can from your company? “Check to see if you have maxed out contributions to your plan,” says Linda Erickson, Founding Partner and Financial Advisor at Erickson Advisors in Greensboro, North Carolina. “If not, inform your employer you want to contribute (and get the employer match available) up to max limits for 2020.”
Step Two: Beyond the match, look at the contribution limits. “The employee could increase their contribution into their employer retirement plan (401(k), 403(b), or 457(b)) if they haven’t already maximized their deferral and if the plan allows them to change their deferral election,” says Cindi Turoski, a managing director at The Bonadio Group in Albany, New York. “They have to change the deferral election before they receive the bonus.”
Even if you take the consensus choice and place your bonus in your company plan, you may find that there’s a twist. And that could be in your favor.
“Many 401(k) plans now offer a Roth option inside their employer sponsored plan,” says Jeff Busch, Partner of Lift Financial in South Jordan, Utah. “This is the way to go if it is available to you and you feel like taxes could be higher in retirement than they are today. A Roth 401(k) allows you to contribute after-tax dollars and also receive the match from your employer. Just remember that the employer match portion will be taxable in retirement, but the growth on your own contributions could be tax-free when you take it out.”
#2: IRA (Traditional)
What do you do if you don’t have a company plan or you’ve hit your contribution limit there?
“If you want to save even more or can’t contribute to your employer retirement plan, you can contribute to a traditional IRA for yourself and/or your spouse (spousal IRA),” says Turoski. “The contribution to each IRA can be up to the lesser of your earned income or $6,000 ($7,000 if age 50 or over) for you and your spouse. You have up until April 15, 2021 to make your contribution for 2020. There are income limits on being able to deduct the contribution if you participate in an employer plan. Even if you can’t get a deduction, the nondeductible contribution creates basis, which means a portion of your future distributions come out tax-free. In the meantime, the account compounds tax-deferred, enabling you to accumulate more wealth.”
While tax-deferred IRAs have been the traditional venue for retirement savings, the guidelines do tend to get complicated.
“These accounts have specific rules on when you can fund them depending on income so research the benefits and rules of each account before you write the check,” says Morgan. “You will have to go through hoops to open an account and determine which is best for your tax situation but those are not large obstacles to this option.”
#3: IRA (Roth)
Again, with IRAs you have a choice. Depending on your personal tax strategy a Roth IRA can present a more favorable option. “Assuming there is something left, take after-tax money which arrives in your checking account and put that into your Roth IRA, and if you are married, max out your spouse’s Roth IRA as well,” says Erickson. “Don’t forget to add in the catch-up amount if you are over age 50. That is, $6,000 for younger workers and $7,000 each for those over 50.”
Roth IRAs turn the table on traditional IRAs. In the latter, you assume your tax rate will be lower in later years. With Roths, however, you’re betting tax rates will be higher.
“If eligible, a Roth IRA can provide tax exempt growth on funds,” says Randy Carver, President and CEO of Carver Financial Services in Mentor, Ohio. “There is no required minimum distribution and, while not recommended, your investment can be withdrawn at any time without penalty or tax. The question is how much can you afford to put away. While some people may consider tax deferred IRA’s to get a write-off today, we believe most people will be better off in the long run with the tax-exempt Roth.”
Even if you earn too much to contribute to a Roth IRA, there’s still a way you can utilize this intriguing device. It’s called a “backdoor” Roth IRA. It involves an intricate dance, and you’d best be advised by someone intimately familiar with the process.
“If your income is too high to qualify for a contribution directly to a Roth IRA, you might be able to do a backdoor Roth IRA,” says Turoski. “This works best when you have no other pre-tax IRA, SIMPLE IRA, or SEP IRA balances. You would make a nondeductible contribution to a traditional IRA, then convert it to a Roth IRA soon after. The value of the IRA when converted would be included in taxable income that year, but the nondeductible contribution provides offsetting basis. If the IRA is held in cash and doesn’t earn anything before being converted, the conversion would be tax-free. Note that if you have other pre-tax IRA, SIMPLE IRA, or SEP IRA balances, the conversion would be partially taxable. This can be resolved if you can roll the pre-tax balance up into an employer retirement plan to clear the deck for a backdoor Roth IRA.”
#4: Health Savings Account (HSA)
In the realm of retirement savings vehicles, there’s a third way. It may not appear that way at first. If you get creative and stick to a strict financial discipline, you may find yourself making this choice.
“Contribute to a health savings account (HSA),” says Rafael Rubio, president of Stable Retirement Planners in Southfield, Michigan. “An HSA is a health-related benefit you may be able to tap into which you can put pre-tax money and use it towards medical costs whenever you want, not just during the plan year. There’s no limit to how much can be rolled over at the end of the year. To qualify for an HSA, the IRS requires you to be on a high-deductible health care plan (HDHP).”
An HSA offers all the immediate tax savings of a traditional IRA with the added long-term tax savings of a Roth IRA. This powerful savings tool is growing in popularity, especially among younger savers. It’s a valuable spending alternative when it comes to your year-end bonus.
“Employees with an HSA can also max out contributions,” says Tiffany Lam-Balfour, Investing and Retirement Specialist at NerdWallet in San Francisco. “HSAs have triple tax advantages (contributions are made pre-tax, investments grow tax-deferred and you don’t pay tax on withdrawals for qualified medical expenses) and since healthcare spending generally increases as we age, building up your HSA balance can be beneficial for retirement. For 2020, you can contribute up to $3,550 for a self-only HSA and up to $7,100 for a family HSA. The catch-up contribution for those aged 55-plus is $1,000.”
#5: Child IRA
The road to retirement isn’t always about you. It can also include your children and grandchildren. Let’s say you’ve been extremely lucky and your year-end bonus more than satisfies your own retirement needs. Now it’s time to focus on the next generation.
It’s called a “Child IRA,” and it is perhaps the most overlooked retirement savings vehicle there is. It’s easy to create a Child IRA and it can address everything from the problems associated with college debt and the eventual collapse of Social Security.
Erickson says, “If you still have money available and have children who have a part time job, or adult children who don’t contribute as much as possible, establish and gift a full $6,000 for each child, or send a deposit to the adult child’s Roth IRA. That’s a true Happy Holidays!”
Who knows? If you can string together several years of big year-end bonuses, you can turn your teenagers into million-dollar retirees before they graduate from high school. A Child IRA is truly a gift that keeps on giving.
#6: Reducing Debt
If you don’t have kids eligible for Child IRAs, there’s still plenty of good things you can use your bonus money for.
“A year-end bonus is typically not something that people plan on having, and may not have worked into their budget,” says Anthony Pellegrino, Founder of Goldstone Financial Group in Oakbrook Terrace, Illinois. “Since it is extra money, the first thing to look at is paying down any high interest debt, such as credit cards.”
“It doesn’t make much sense to chase a 6% investment return if you are paying 18% in interest on credit card debt,” says Rob Comfort, President of CUNA Brokerage Services Inc. in Madison, Wisconsin.
This is literally an example of paying it forward.
“Paying down or off any debts that create monthly payments would be a win,” says Morgan. “By freeing up future monthly cash flow you can more aggressively save for retirement once those debts are gone. The emotional benefit of paying down debt and lowering monthly payments is hard to calculate but it is definitely an upside to this option.”
#7: Emergency Savings
Do you find that you’re managing your debt just fine and have it under control? Here’s an idea when it comes to spending that extra cash you get at year end. “You can use the bonus money to shore up an emergency fund,” says Pellegrino.
This classic financial planning maneuver also protects you for the years you don’t get a bonus.
“Look at the bonus as a liquidity fund in case you don’t get a bonus the next year,” says Parrish. “You may not have a job then, the company may not be paying bonuses then, or you may just plain need the money for an emergency. Consider the bonus an opportunity to put money away for ‘future you.’”
#8: Investment Savings Account
Lastly, in terms of savings, you always have traditional non-retirement savings vehicles.
“Maybe you want to save for retirement but like to know you can access those funds for other financial goals without penalties,” says Morgan. “Anyone can open a non-retirement investment account and invest as little or as much as they would like. While you will not receive the tax benefits of a retirement account you will maintain access to the funds and they will be working for you.”
It’s not just opening up a brokerage account, either. There are many ways to save.
Parrish says, “Over 30 years ago I worked it out so that my annual premium on a cash value life insurance policy came due around bonus time. That way I got in the habit of investing some of the bonus each year in the form of the premium. Out of sight; out of mind.”
#9: Paying Off Regular Expenses
When you’ve exhausted your savings and debt priorities, you can begin to turn to everyday expenses. These are the type of expenses you’re already decided to make but might represent a strain on your household budget. For example, you can pay in advance for subscription services like cable TV, internet and, yes, even print magazines.
Other things to use this extra bonus money for include “setting aside cash to meet near term commitments, making a 529 Plan contribution (perhaps bringing the annual contribution up to at least the state tax deduction limit as applicable), making annual exclusion gifts, and fulfilling charitable commitments (perhaps using cash or preferably long term appreciated assets),” says John Voltaggio, Managing Director at Northern Trust Wealth Management in New York City.
#10 Having Fun
Finally, and you might say the best is saved for last, use some of that year-end surprise to treat yourself to something you wouldn’t normally do.
Comfort says, “If you have competing desires with the bonus, try this Rule of Three: use 1/3 to pay down debt, save 1/3 in your retirement accounts and use the final 1/3 on something fun!”
You earned it. You may as well enjoy it.