What to do with your year-end bonus?

As we approach year-end, some of you might be eagerly waiting for comp memos to hit your inbox.
The question is, when that bonus gets deposited into your bank account, what are you going to do with it?  Are you planning a weekend getaway?  Splurging on something? Or do you plan to save it?  This article discusses a few ideas on how to use your year-end bonus.

1. Save a portion for taxes*

Probably the most important thing to do with your bonus is to save a portion of it to pay taxes.  For bonuses less than $1M, most employers will only withhold a flat 22% (flat 37% for bonuses above $1M)¹.  This means that if you are in a higher tax bracket than the 22% bracket (which most of you are), not enough taxes are withheld, and you may end up owing the IRS when you file your taxes. 

A good way to know how much to save for taxes is to do a “back-of-the-napkin” calculation by estimating your taxable income, which depending on your filing status, will tell you your marginal tax bracket.  Once you know your marginal tax bracket, figure out the difference between what was withheld (from your paystub) and what you actually owe, and that will tell you approximately how much to put aside for taxes.  Alternatively, you can pay a tax advisor to run an estimate for you. 

2. Pay off your student loans

Are your student loans weighing heavily on your shoulders?  If so, after you have saved enough to pay for potential taxes* due on your bonus (see #1 above), it could be a good idea to pay off a large chunk of your student loans.   You can find student loan repayment calculators online that will show you the impact of making a large pre-payment and how much you would be saving in interest.

3. Invest for your future

First and foremost, if you have not done so already, please max out your 401(k) contribution for the current tax year.  This has to be done before December 31^st of the current year.  Note that your employer should allow you to take a portion of your bonus and apply it toward your 401(k) before it is paid out to you (if your bonus is paid out before 12/31).

Another good place to invest your bonus is to fund a Roth IRA.  Roth IRA dollars grow without getting taxed and can be withdrawn in retirement tax free**.  That said, you likely make too much money to contribute directly to a Roth IRA, so you have to take an extra step.  First, you would want to open/fund a non-deductible Traditional IRA, then immediately convert it to a Roth IRA.  This strategy is known as the “Backdoor” Roth IRA.

Finally, when those retirement account buckets are completely full and you still have money left over, then you can think of investing in other after-tax vehicles.  One thing to consider here is to make sure these vehicles are built tax efficiently, so that you are not making your tax burden worse.

Sidebar: Paying off student loans versus investing for your future

The decision of whether you should invest your bonus versus paying off your student loans should not always be based on what makes most sense mathematically.  Let’s take a hypothetical example in which you could earn an 8% average rate of return on your investments, and you have a 3% interest rate on your student loans.  It’s true that the delta of 5% (8%-3%) would be your net return on investment.  However, the psychological burden of having debt is not to be discounted.  You know yourself best, just do what feels right. 

4. Build up your emergency fund

I know this is a boring topic, but nonetheless so important.  We never know what the future holds, so it’s important to cover your bases by having enough money in savings in the event you get laid off or you incur large, unexpected expenses.

The idea here is to have enough cash saved up to get you through a potential extended period of time without regular income.  Typically, we recommend having anywhere between 3-6 months’ worth of essential expenses saved up in a highly liquid, safe place. 

For this purpose, I like high-yield savings accounts because they are paying better interest than traditional savings accounts.  Also, because they are offered by non-traditional brick-and-mortar banks, they will likely not be at the same institution as your checking and savings account, which means the account would be “out of sight, out of mind”.  Let’s be honest, for a lot of us, when we have money in a savings account, it is really just an extension of our checking account.  Having your emergency fund in a separate place would remove the temptation to move money from savings to checking just to buy something.

*Neither SharpEdge Financial LLC, its staff, nor Eagle Strategies LLC or its advisors or affiliates provides tax, legal, or accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions. SharpEdge Financial LLC is not owned or operated by Eagle Strategies LLC or any affiliates. Eagle Strategies LLC & NYLIFE Securities LLC are New York Life companies.

**Contributions to a Roth IRA may generally be withdrawn at any time without tax consequences. Earnings may generally be withdrawn tax-free if the account is held at least 5 years and withdrawals are made after the account owner reaches age 59 ½. If earnings withdrawals are made before the 5-year period or age 59 ½, income taxes are due, and a 10% federal tax penalty may apply.

1. Source: https://turbotax.intuit.com/tax-tips/jobs-and-career/how-bonuses-are-taxed/L7UjtAZbh (12/01/2022)