Dear Linda,I will be receiving an unexpected bonus shortly. I want to make sure I am smart with the money and have a plan in place for what I am going to do with it. Any ideas?
Sincerely, Lucky Lady
Dear Lucky Lady,
Your question is a common one we receive around this time of year as companies complete their prior-year reporting and issue bonuses. You are wise to create a strategy before spending the bonus. Without knowing the details of your situation, here are some general thoughts to help you get started.
1) Obtain a detailed tax projection from your tax preparer so you know how much of the bonus will be yours to keep after taxes. If your employer withholds less taxes than projected, reserve the balance so you have it available when it is due at tax time. You can also increase your W-4 withholding for the rest of the year. Withhold at least enough to avoid the underpayment tax penalty.
2) Pay off high-interest rate debt including credit cards, personal loans, or student loans. For example, some student loans charge close to a 7% interest rate. If you pay that loan off, it is as if you earned a risk-free rate of return of 7% on the money. However, if you plan to qualify for a student loan forgiveness program, you may not want to rush and pay it off. It will depend on your situation.
3) Build a cash emergency reserve. If you don't have this in place, reserve at least three months' worth of expenses in a high-interest rate savings account. You can reserve a larger amount if you are worried about losing your job, are expecting to move soon, or simply feel more comfortable holding a larger amount of cash. Realize that the interest rate on a savings account will not keep up with inflation over the long-term, so keep this account at the minimum balance required for your personal situation.
4) Increase your retirement savings at work. If your employer offers a retirement plan, you can save up to the IRS limit for 2018. For example, if you have a 401k or TSP, the limit is $18,500 if you are under 50 years old and $24,500 if you are over 50 years old.
Increase savings elsewhere. After you have implemented the first four suggestions, you may consider one or more of the following options:
- Save to a Roth IRA or Traditional IRA, if you qualify.
- Maximize your Health Savings Account (HSA), if you qualify.
- Consider after-tax 401k contributions, if available. After-tax 401k contributions are different than Roth contributions. There is no tax deduction on the savings, but the money will grow tax-deferred and can be rolled into a Roth IRA (without limitation) after you leave the company. Not every company offers this option.
- Save to a Brokerage account. There is no tax deduction on contributions to a brokerage account, but it is still a good option. Qualified retirement accounts (such as a 401k or TSP) are taxed differently than a brokerage account. When you have a mix of account types, you have more flexibility to utilize asset location strategies and manage your tax bill in retirement.
- Save to a donor-advised fund (DAF). A DAF is an investment account for charitable purposes. You invest as you would with any investment account and when you are ready to donate to a qualified charity, use the money from the DAF. Assuming you are eligible for charitable deductions, you will receive the deduction when you place money into the DAF, not when money is withdrawn. If you are charitably inclined and expect to be in a higher tax bracket now than in the future, take advantage of the tax deduction now while it provides a greater benefit to you.
- Save $10K to an I-Bond. I-Bonds are government bonds adjusted for inflation. You are allowed to buy $10K each calendar year per person.
- Fund other goals you may have. Confirm you have enough life and disability insurance, and if not, use the bonus to become adequately insured. If you are saving for a house, earmark some of the bonus for the down payment. If you are saving for a child's college education, consider a 529 plan.
Work with a fee-only, fiduciary advisor and tax preparer if you want a customized strategy that prioritizes your available options in detail.