Good news: More workers than ever may be getting a bonus next year.
A report released in August by human resources services firm Aon Hewitt showed more than 90 percent of companies surveyed increased the amount of money set aside for performance-based bonuses in 2015.
While workers may celebrate getting a boost of cash that’s outside of salaried compensation in the coming year, it’s more important than ever for individuals to put this money to work for retirement rather than think of it as money that’s above and beyond normal income.
Why? The report also showed companies are not raising salaries at the same rate, meaning companies are leaning into using bonus funds rather than fixed salary hikes to compensate workers, according to Aon’s Kenan Abosch, who leads the firm’s compensation consulting practice.
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That means you’re on your own to make sure you’re allocating your money into the right places. That’s not all—there are also some very good behavioral reasons to invest your bonus.
How does a bonus get taxed?
A bonus is taxed the same way as your regular income, but the withholding from your paycheck might be different.
Bonuses are considered “supplemental income” by the Internal Revenue Service, which means the IRS suggests a flat withholding of 25 percent from bonuses, and many employers follow that method. (Remember that withholdings are meant to be an estimate of how much you’ll owe at the end of the year, not the actual tax itself.)
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Other employers use the aggregate method, in which your whole bonus is added to your regular paycheck. The combined amount is then subject to taxation at the normal income rate, as if that cumulative amount were representative of what you make every paycheck; the tax rate, therefore, could be higher (or lower) than 25 percent.
Here’s a few tips to strategically use your bonus to add to your retirement savings.
1. Beef up your 401(k). Before you add your bonus to your 401(k) plan balance, check with your employer about how bonuses are handled. In some cases, your company may not allow you to make 401(k) contributions using your bonus.
In others, your 401(k) plan may be set up to withhold the same percentage from your bonus as from your paycheck. Thus, if you typically contribute 10 percent from every paycheck to your 401(k), that same amount could be withheld from your bonus, unless you say otherwise. So in the case of a $15,000 bonus, $1,500 would go into your 401(k).
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Of course, you can’t contribute more than the annual limit, so be sure to check how much you’ve contributed for the year to date. The contribution limit for your 401(k) for 2014 is $17,500, or $23,000 if you’re over age 50.
Starting in 2015, the maximum you will be able to contribute to a 401(k) is $18,000 per person. If you are 50 years old or older, you can contribute an additional $6,000 in 2015 for a total of $24,000 per year.
“Many people don’t realize that you can participate in a company plan and still fund a traditional or Roth IRA.”
Don’t assume that a lump-sum deposit is best, especially if your employer matches your 401(k) contributions. A single large deposit might not get the same amount of matching dollars that a comparable amount would if you spread the deposits over time.
Certified financial planner Alex Benke, Betterment’s director of advice products, notes that it depends on your employer’s matching structure.
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2. Take advantage of multiple accounts. Depending on your income and whether you or your spouse are participating in a company retirement plan, you might be able to reduce your taxable income further by contributing to your flexible spending account (the maximum is $2,500, $5,000 for dependent care for 2014), a health savings account (the maximum for a family is $6,550 for 2014) or a traditional IRA.
Many people don’t realize that you can participate in a company plan and still fund a traditional or Roth IRA. So you could contribute to your 401(k) for 2014 and contribute to a traditional or Roth IRA for 2014 (up until April 15, 2015), or contribute to a traditional or Roth IRA for 2015—or a combination of those.
As the IRS notes, “You can contribute to a traditional or Roth IRA whether or not you participate in another retirement plan through your employer or business. However, you might not be able to deduct all of your traditional IRA contributions if you or your spouse participates in another retirement plan at work. Roth IRA contributions might be limited if your income exceeds a certain level.”
3. Weigh paying debt vs. investing more. If you have high-interest debt in the form of credit cards or personal loans, your bonus money should go to pay those. For example, instead of paying off the $10,000 you owe to a credit card that has a 14 percent APR with monthly payments of $500 over almost two years, eliminate that debt immediately with your bonus funds in one payment and save yourself almost $1,500 in interest. (Figures were calculated using the Bankrate.com calculator.)
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Not all debt is bad, however. If your bonus is sizable, you might be faced with a decision between paying off “good” debt, such as a low-interest student loan debt or a mortgage, versus putting that money into an investment.
If you have a low-interest student loan or mortgage—with, say, a rate of less than 5 percent—then it might make sense to invest before accelerating payoff. Paying a loan off is like getting a guaranteed rate of return equivalent to the rate on your loan. Guarantees are good, but they come at a cost that you need to judge based on your other goals.
Why invest your bonus?
In addition to shoring up retirement, there are more reasons to invest your bonus rather than spend it. In short, investing it can make you happier over the long run. Here’s why.
Research from Nobel Prize-winning economist Daniel Kahneman and others has shown that increases in happiness are linked to continuous upward spending on your lifestyle, not merely achieving a certain level of wealth.
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For example, if your spend rate has been $150,000 per year for the past five years, you may end up less happy than someone who has been increasing their spend, and income, every year for the last five years to get to $150,000.
Why? If you’re in the second group, you are getting a slightly larger piece of pie each year—and that just feels good. Spending a little more than you did the year before makes you a little happier than spending at the same rate year after year. It makes you feel like there’s progress on the journey of life.
By contrast, when you rapidly spend down a bonus, gift or windfall, you go from being flush to feeling broke—and deprived. That often happens to lottery winners who go broke after a few years.
They hiked their spending to a level that was unsustainable rather than doling out their winnings year by year, and when they have to go back to their old lifestyle, it feels lousy.
When you create a happiness annuity, you use your windfall to give yourself a raise—or a little extra to spend—every year with smart investing.