If you're among the lucky folks who received a bonus this year, you most certainly have reason to celebrate. But while you may be tempted to spend that newfound money on whatever your heart desires, in the long run, you'll be much better off if you use it responsibly. Here's where to start.
1. Build your emergency fund
If you don't have an emergency fund, you're not alone. Most Americans have less than $1,000 in the bank. If you're among those falling short on savings, the first thing to do with your bonus is create an emergency fund, or build up the one you already have. As a starting point, you should aim to have enough money to cover three months of living expenses. If you're a homeowner or have dependents, your savings target should be six months' worth of living expenses or more. Having savings on hand is the best way to protect yourself should you suddenly get hurt, fall ill, or lose your job, so until your emergency account is fully funded, contributing to it should be your first priority.
2. Pay off bad debt
Carrying a credit card balance can cost you loads of money in interest fees, so the sooner you pay off what you owe, the better. Remember, unlike mortgage or student loan debt, credit card debt is considered the bad kind -- the kind that can send your credit score plummeting if you're not careful. Imagine you're carrying a $5,000 balance on your credit card that you plan to pay off over two years. At 12% interest, which is what you might be looking at today, you'll wind up wasting a good $650 in interest charges. But if you use your bonus to pay off that balance immediately, you'll not only knock out your debt, but save yourself $650 in the process.
3. Save for retirement
Most people require between 70% and 80% of their pre-retirement income once they're no longer working. And if you're counting on Social Security to provide all the income you'll need in retirement, think again. Social Security is only designed to replace about 40% of your pre-retirement income, so unless you're willing to make sacrifices in your old age, you'd better be prepared to bridge that gap. To that end, you can put your bonus to excellent use by allocating it to a retirement account. And if you put money into a traditional IRA or 401(k), you'll lower your tax burden for the year you make your contribution. For 2016, you can contribute up to $18,000 to a 401(k) and $5,500 to an IRA, and if you're 50 or older, those numbers jump to $24,000 and $6,500, respectively.
Even if retirement is several decades away, saving early on can yield big results. Imagine you receive a $5,000 bonus and put all of it into a retirement account when you're 27 years old. If your investments manage to generate an average annual return of 8%, which is actually below the stock market's average, by the time you reach 67, you'll have grown that sum into an impressive $108,000.
4. Save for important goals and milestones
Once you've built your emergency savings, paid off bad debt, and kick-started your retirement fund, the next best thing to do with your bonus is apply it to major life goals. Perhaps you're planning to buy a home within the next few years. Or maybe you have adult children with marriage on the brain and are hoping to help finance their weddings. No matter what milestones you're saving for, that bonus can go a long way toward helping you get there.
5. Start investing
Investing your 401(k) or IRA to fuel your retirement savings is one thing, but investing for the short term is another. When your retirement investments earn money, you can't touch those profits until you're old enough to start taking withdrawals (currently age 59-1/2). But if you invest money in a traditional, taxable brokerage account, you have the option to cash out your gains and use that income as you please. You might treat yourself to a nice vacation, upgrade your car, or ship your kids off to that pricey summer camp whose brochure you've been eyeing for years. Though you will have to pay taxes on your earnings, the good news is that whatever profit you generate is yours to spend. Another option? Get your kids involved in the process, teach them about investing, and use your investment gains to start or add to their college fund.
While bonuses are a welcome reward for a job well done, the thing to remember is that they're usually not guaranteed. Before you blow that lump sum of cash, imagine that this year's bonus may be your last. It'll probably change the way you think about spending it.