What Should I Do With My Annual Bonus Before I Retire? [Video]

An annual bonus is an blessing, but you might be wondering what’s the best way to use extra cash before you retire? In this video, when clients ask “what should I do with my annual bonus,” we use this framework to consider when to watch out for taxes, how to use the money to plan for retirement, and mistakes to watch out for!

Video Transcript

Your annual bonus just hit your bank account. Congratulations! Don’t spend it all in one place! You want to make the best use of it. But does that mean you spend it, save it, invest it, or something else?

Hi, my name is Michelle! And I’m a financial advisor here at Financial Design Studio; where we help business leaders build tax efficient retirement plans. Today I’ll break down the smartest ways professionals can put their bonus to work and the common mistakes to avoid.

What Kind of Bonus Did You Get?

Before you can start planning, you need to know what you are getting. Bonuses come in a couple of different forms. You can get them in cash, or you may just receive additional company stock.

In addition to knowing what types of bonus you’re going to be receiving, it’s really important to know the timing and when you’ll receive and how you’ll receive those bonus funds. For example, maybe you’re gonna receive this monthly, so in the case of a commission. Or maybe this is something you receive in a lump sum. For example, last year, your team or the project that you were working on reached its goal and so you’re now being paid out this bonus. But you’re gonna receive it in February, March or April of the following year.

1. How to Prepare for Taxes

One of the biggest things that we think about when we’re receiving our bonus is really the taxes that are being withheld from this bonus amount. This is something, it’s really, we wanna make sure this is taken care of because the rest of the amount is something that we can do something with.

It’s very common that your employer already has a standard amount that they’re gonna withhold from this amount you get. So let’s just assume that you receive $50,000 in a bonus. Your employer might say we’re going to withhold 20% for federal income taxes on this amount you’re receiving. Now, you have to think through is, is 20% good for you or are you in a different tax bracket?

Let’s say that you fall into the 24% tax bracket on this income. Well, we can quickly see that what’s being withheld on this amount, that 20% is going to fall short. How is this 4 % is going to get paid?

Now the difference of this, that 4% that we’re talking about. And so as you go throughout the year and you have your paycheck, your employer’s already withholding that income tax for you. However, you need to know if it’s not withholding enough because your income.

Watch Out for Underpayment Penalties

Now you need to take care of this additional amount. The reason that you NEED to take care of that is because this 4% difference could cost you in underpayment penalties. At the end of the year, if you owe more than you’ve withheld from your paycheck, then the government will say, “you should have paid in more all along the way as you were earning it.” And so the government will actually charge you an underpayment penalty.

You need to know all the income you’ve earned by the end of the year, and that you’ve paid the taxes you should have within a certain timeframe. This is why planning is so important. Otherwise you get to April and you don’t have a happy surprise.

Where to Keep these Withholdings?

Even these funds that you’re withholding for taxes, be sure that that money is doing something. So for example, if it takes you a month or two to now sit down and actually calculate the taxes you’re gonna owe, it’s important that you’re earning in a high interest savings account, and that you’re earning interest on these funds as they sit there.

2. Where to Spend Your Bonus?

Okay, now that we figured out how much we need to withhold for taxes from this bonus you’re receiving, now really kind of comes the fun part. This is figuring out what we’re gonna do with this money. We’re really thinking about goals we already have.

The way we set financial goals is by determining here’s how much we want to save for retirement or college education. So we have all of those defined already. And then as we build your plan, we break that into now each year or each month what you need to be doing to fund those along the way.

So now, all of a sudden, when we receive this one bonus amount, for example, it could throw everything off because you could see that additional amount in your bank account or in your investment account. You already know what you are doing monthly. But now you have this large amount. What do I do with this? But there’s so many things you could do with it, right? That’s fun!

Opportunities for Your Bonus

And so let me help you think about some ways to consider this. So for example, in addition to thinking about retirement, things like that, a lot of times our clients will also say, you know what, we want to pay for our child’s college education. So we want to fund a 529 account, so we’re setting that money aside. And instead of having that happen on a monthly basis, a bonus might be a great way to fund that.

In some years it can be different. You could say, maybe we needed to buy a new car. Maybe you had a remodeling project at home that you’ve said, when we get a bonus, we want to fund it with that. Maybe because of what you’ve received, and maybe you received a little bit more than you thought you would, you actually could give a little bit more.

And it is really important to consider goals that you have in order to really spell out where this money’s gonna go. Really what we’re doing is we’re coordinating the other pieces of income or benefits that you’re receiving. And we’re saying this is the best plan to use these in the most tax efficient way.

And what percentage of this kind of allows me to celebrate the reward of your hard work. So you might say, we’re gonna do those things like a 529 or giving, but with this portion of this, maybe $5,000 of that, our family’s gonna go on a vacation or your spouse and you are gonna go on a vacation. You should make sure you feel rewarded for the work that you’ve done.

3. Common Mistakes People Make with Bonuses

So now let’s touch on some common traps that people fall into when they receive their bonus.

First is something called lifestyle creep. And what this means is that people start spending more with this bonus they’ve received without a plan they’re making purchases that they really can’t sustain. You’re really increasing your whole cost of living. And that is something that we really want to watch out for. So it’s really important with lifestyle creep that you’re not just increasing your basic living standard based on this one time amount that you received.

Secondly is that we underestimate taxes. We already talked about this, but really knowing about what you’re going to owe, because if you don’t, there could be penalties based on the amount that you didn’t pay in. So it’s very important, again, to have a plan for those taxes and know what you owe.

The next one is not using money to advance your bigger goals. And so like we talked about, having a percentage that you’re saying, this is what’s going to fund those goals that we have for the future. A bonus is a great way for those to actually start to be funded. So again, then it’s not coming from your monthly income, your monthly salary, but it’s actually from this one time amount, you’re setting it aside to cover those goals that you have, so you know you’re funding them.

Another is that a bonus can disappear quickly or it can meaningfully change your financial future. Really the difference is in the planning. You have a plan, you put the funds where they need to go instead of making other choices that don’t necessarily get you where you want to go.

And finally, bonuses don’t always get paid in cash. And this is really important to know and consider because if yours isn’t paid in cash, now there’s an extra step of something you need to do. You might need to sell that stock to be able to fund those goals, or maybe you just simply need to move those shares of stock to those other goals rather than selling it if there’s any tax consequences of that. So it’s really important to know what you need to do.

Next Steps for Your Retirement Plan

If you are someone who’s starting to think about retirement and you have questions that internet searches just can’t answer, we’d love to help you. Click “Get Started” on our website to schedule a free retirement review with our team.

And thank you for watching!

Bonus: Free Retirement Planning Guide