Whether it’s an end-of-year bonus, a small inheritance, gift or legal settlement, a sudden infusion of unexpected cash is always a welcome event. It’s often a temptation, however, to think of these occasions as “found” money that’s outside the scope of your financial plan and therefore readily available to spend.
There’s certainly nothing wrong with using part of a one-time cash windfall to treat yourself, but it’s important to keep in mind that taking care of your long-term needs should always come before allocating resources to shorter-term wants and wishes. Managing cash flow is a key part of the financial planning process; one about which your advisor can offer valuable insights and guidance.
First and foremost, don’t fall prey to the common mistake of thinking about your year-end bonus in gross rather than net terms. Keep in mind that, depending on in the state where you live, federal and state withholding could reduce the amount of the bonus that you actually receive by one-third or more. If you’re planning to spend $5,000 and save $5,000 of a $10,000 bonus, you’re probably setting yourself up for failure since you actually may only net around $7,000 after withholding.
If you’re fortunate enough to receive a very large bonus, make sure you understand all of the tax implications. It potentially could push you into a higher tax bracket, causing you to owe additional taxes on that year’s income. One possible solution, if your employer allows it, is to defer taking your year-end bonus dollars until after the first of the year. This may help you better manage your income for tax purposes while at the same time saving more for retirement. Of course, deferring income only makes sense if you think you will be in the same or a lower tax bracket next year. You don't want to be hit with a larger tax bill the following year if additional income would push you into a higher tax bracket.
Prioritize your needs
Instead of having to set aside money each month to build up a cash reserve for emergencies like unexpected expenses or the loss of a job, consider tagging your bonus for that purpose and drop it into a savings or money market account. Alternatively, you could use it to fund a shorter-term goal (saving enough to make a down payment on a home purchase), which will then allow you to redirect future savings towards longer-term goals like retirement.
Assuming you haven’t exceeded your maximum allowable retirement plan contribution, perhaps the best use of a bonus would be to put the lion’s share of it into your employer 401(k) or 403(b) plan. Not only will this allow you to avoid a bigger tax bill, but it will move you further and faster down the path toward a more financially secure retirement. Some bonus recipients take an opposing strategy and go so far as to alter their retirement plan settings so that no plan contribution is taken out of their bonus check. Resisting this temptation and maintaining a consistent contribution level on your bonus benefits your future.
If you happen to be later in your career, chances are you’ll probably be receiving a larger bonus than someone who’s just starting out. This could provide you with a tremendous opportunity to get your retirement savings back on track—if you’re a little behind the curve—with a significant catch-up contribution.
When it comes to a bonus or other small windfall, it's essential that you consider your entire financial picture—the money you owe now and the money you want to put away for your future needs, wants and wishes. Sometimes shorter-term concerns (paying off high-interest debt) will take precedence, but typically longer-term savings will pay off the most in the end. Together, you and your advisor can make those determinations based on your specific situation and plan goals. While it takes discipline to put together and execute a strategy, it results in increased confidence that you’re using your money wisely rather than giving in to the urge for instant gratification.