Do you get an annual or semi-annual bonus at your job? I always loved those… But what’s the best thing to do with the money?
Thankfully, you usually know ahead of time that you’re going to get bonuses, even if you don’t know the specific amount. They’re described in your job offer or in your performance review.
You have plenty of warning that this money is coming, so take some time to create a plan for it! In fact, make your plan specific enough (you know, percentages and names of accounts) that it’ll be like falling off a log to actually do the work when the time comes.
Bonuses Are a Great Opportunity to Leapfrog Towards Your Goals
In the world of tech, you probably have several tools you can use to improve your finances. You have a good salary. You get a 401(k) match. You get company stock. In that sense, bonuses are simply one opportunity of many to cultivate the life you want, both now and in the future.
Bonuses have one particular advantage over, say, saving from your salary: most of us aren’t accustomed to living on our bonuses. So, you can put 100% of your bonus to work towards your goals, and you wouldn’t “feel” it in your day-to-day life.
Imagine if you’re trying to save up, for example, for a house downpayment, and you’re diligently saving $1000/mo to a downpayment account. Now you get a $12k bonus, and overnight you squeeze a year’s extra saving towards your goal. How motivating is that?
[If you are relying on your bonus income in order to support regular, ongoing expenses, I’d try really hard to ratchet my expenses down so that they’re covered by my salary. The effect of “mental accounting,” ex., “salary is for monthly expenses and bonus is for saving” is powerful. Sometimes mental accounting can make us do stupid things with our money, but in this case, it can make saving money a heck of a lot easier.]
You have this same “leapfrog” opportunity every time you get a chunk of money you’re not accustomed to getting frequently, like vesting RSUs or an inheritance or a tax refund.
Make A Plan Ahead of Time
We’re dealing with two challenges when it comes to bonuses:
- Knowing what is the best use of the money for you, specifically
- Actually doing the right thing when you receive the bonus money
Start with Values and Vision
Above, I mentioned the idea of “cultivating the life you want,” and how important that is. To get to that life, however, you need to spend some time thinking, really thinking, about what it should look like for you. What’s truly important to you? Now? 10 years from now? You absolutely need clarity on that in order to make the best choices with your money.
This is no small work. When I first start with a client, in fact, we spend 2 90-minute meetings simply (“simply”?) discussing attitudes towards and memories of money, values, vision, and goals. No numbers. No “What’s your 401(k) balance?”
Let me tell you, people get a lot more excited about boring sh*t like savings rates when they’re able to visualize a life they’ve always wanted, and now see a path to get there.
This is what all financial decisions should be rooted in, not shooting straight to “what do I do with my bonus?” Really, you could mentally insert the above discussion into all of my blog posts.
Create a “Policy” for Bonuses
Next you need to take the step from that motivating “vision” to more practical how-tos. And for that, I like using financial planning “policies” with my clients. Policies are simply a list of rules that dictate how you behave in a specific financial situation.
The point of creating and using policies is to make the decision ahead of time, when you’re thinking clearly. And to avoid making the decision in the heat of the moment, when your lap is covered with dollar bills or you’re standing in a Williams Sonoma or staring at kayak.com.
I think you should (eventually) have a policy for every part of your financial life. In this case, I encourage you to write a policy for when you receive bonuses. The policy might look like this:
When I receive a bonus, with the after-tax amount I will:
1. Spend 10% now on whatever you want (to avoid a sense of deprivation)
2. Save 70% for house downpayment.
3. Save 20% towards financial freedom/early retirement.
Boom. Done. That’s the policy. No, it’s not complicated or long. That’s the point. It’s short, clear, and simple…all the qualities you’re going to need to actually adhere to it.
“Must-Have” Policies. While you can—and should—tailor your policies to the life you want, there are some rules that we should probably all follow when we get extra money, before getting to the more grandiose “this is my vision of a good life!” policies:
- Pay off high-interest debt.
- Build up your emergency fund.
- Pay off your 401(k) loan.
- Save at least 15% towards retirement.
Move the Money ASAP
If your extra-big paycheck ends up entirely in your checking account, I encourage you to move it to its proper home as soon as possible. Make the extra payment immediately against your credit card. Or move the money immediately to your dedicated downpayment bank account. The longer money sits in your checking account, the more likely it is to simply “disappear.”
You know what I mean when I say disappear: You don’t make any outsized purchases, you don’t do anything big with your money…yet your bank account balance is back down to its normal level after just a few months, even though you’d had such a deliciously high balance after the bonus was deposited.
How Taxes Work on Your Bonus
Your company should automatically withhold taxes on your bonus. In my experience, they usually withhold a flat 25% on your bonus. (They’re allowed to use one of two methods for withholding taxes—percentage or aggregate.) So, by the time the money gets to you, it’s pretty much all yours.
25% might or might not be the right amount for you. It’s unlikely that you will end up owing exactly 25% of your bonus in taxes, but there are so many other factors influencing your ultimate tax liability that it’s really not a bad estimate most of the time.
If you end up owing less than 25%, you can expect a tax refund. If you end up owing more than 25%, you will owe some money come tax time. If you end up owing a lot more tax than that 25%, then it also opens you up to the possibility of a tax-underpayment penalty.
You should find out how your company calculates the taxes they withhold and how much they withheld on your bonus. That said, I have yet to see this being a problem for my clients: 25% is within shouting distance, and “it all comes out in the wash.” Which is to say, I encourage you to figure out what’s happening, but don’t preemptively freak out about it.
If bonuses are a big part of your total compensation, then I encourage you to consult with an accountant to make sure taxes are properly handled (no unpleasant “surprises” come April 15).
Regardless of bonus size, I encourage you to use your bonus money intentionally and thoughtfully, which means you need to start your work well before you actually get the bonus money!
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.