It's that time of year for many employees throughout the country: annual bonus season. It may feel like something to celebrate, but instead of spending this well-deserved windfall right away, plan first.
Among those workers fortunate enough to be getting a bonus, some may have already mentally spent it! Think National Lampoon's Clark Griswold who promised to buy his family a pool with his bonus, only to find out he was receiving a subscription to the jelly of-the-month club from his employer. Lesson learned -- don't count your chickens before they hatch.
But if you have a reasonable assurance of what your bonus will look like, then it's a good idea to start planning. Here are a five ideas on how to spend your newfound fortune:
1. Withhold enough in taxes
Bonus money always looks bigger before taxes. Your employer will most likely withhold part of your bonus in income tax, but is that enough? With the recent changes to the tax laws, it may be hard to estimate your tax liability.
If you already filed your tax return for 2018, you can assume your income is about the same and use that as a guide. If this year's income is higher or lower, you can withhold more or less; but generally speaking erring on the conservative side by asking your employer to withhold more is never a bad idea. An even better idea is to reach out to your accountant and ask their opinion. If it's too late to change your income tax withholding and you think you didn't withhold enough, set aside some money in a separate checking account so there are no surprises come tax time.
2. Catch up on bills
It doesn't make sense to spend a bonus if you owe regular bills. Assuming taxes are paid on your sum, use some of your bonus money to pay any overdue bills. Use this time to estimate any large forthcoming bills too. For example, if your child's tuition bill is due soon, setting aside some of this bonus for that purpose will help ease the pain when the bill comes due.
3. Pay down debt
Using a bonus to pay down debt doesn't sound like much fun, but it will bring long-term satisfaction. First, gather up all the most recent statements for all your outstanding debts including car loans, student loans, home equity loans, mortgages, credit card debt, medical debt, and personal loans.
There are two schools of thought for how to determine which loans to pay first: Some suggest starting with the debt that has the highest interest rate (debt avalanche method), while others suggest knocking out the lowest balance first (debt snowball method). Mathematically speaking, the avalanche method of paying down debt with the highest interest rate first is the best, since high interest is costing you the most. Credit card debt is the worst kind of debt because the interest rate is not only high, but usually it's also variable, meaning the interest rate goes up if broader interest rates rise.
It can help to understand what you owe in interest over the life of a loan by requesting an amortization schedule from the company that administers the loan, or by using a free online loan calculator. You may be shocked by what you will pay in interest over time. This goes for any loan, but it's especially egregious if you look at a mortgage amortization schedule. You may be paying twice for your house -- once in principal, and once in interest.
This information can motivate you to pay down a loan and save on interest. If paying off a loan entirely is out of the question given your cash restraints, you can also see the effect that making an extra payment can have on a loan's maturity. One extra mortgage payment may feel like chipping away at an insurmountable glacier, but it will decrease the payback period, and, if done consistently year in and year out, will significantly save you interest over time.
4. Contribute to emeregency and retirement savings
I'm a big believer in taking small steps first. While it may be tempting to spend a bonus on new furniture or a luxurious vacation, be sure you have enough in an emergency savings account. Most financial experts agree you need three to six months worth of expenses saved in cash. An emergency fund will help support you should you lose your job, or if next year's cash bonus is the infamous jelly club subscription. Having some cash set aside for rainy days can be the difference in not taking on more debt when tragedy strikes. Consider setting aside cash in a separate savings account so it doesn't get commingled with other money, and risk being spent. There are other places to save that pay more interest, such as a high-yielding savings account, certificate of deposit (CD), or a money market mutual fund.
Beyond the emergency fund, assuming there is still money left, add some to your workplace retirement account, likely a 401(k) or 403(b). Adding to a retirement account oays in three ways. First, contributions to a 401(k) or 403(b) are on a pre-tax basis, meaning they will help lower your taxable income and your overall income tax bill for this year. Second, you may enjoy an employer match on money you contribute -- hooray for free money! Finally, putting more money in a 401(k) gets you closer to one day sailing off into the sunset.
Beyond saving some in an emergency reserve or retirement account, if you have children, consider putting some aside for future college costs in a 529 plan. Even if it's a few hundred bucks, something is better than nothing, and by starting sooner you can let the miracle of compound growth work for you.
5. Spend some
Okay, by now we've accomplished a lot with your cash bonus, and you should feel proud. It's time to spend a bit. Take your spouse out for dinner, or go shopping for yourself -- you deserve it. All work and no play makes for burnout, so rewarding yourself for all the hard work you put in is important.
Depending on the size of the cash bonus, you may even want to set up a savings account for a future vacation. Set aside some money now that you can add to over the next several months, and eventually travel somewhere new or get away for some rest and relaxation. Experiences are what we most remember, not a pricy sweater that winds up lost in a closet. Think back to your own childhood: You may have fond memories of loading up the station wagon and singing around the camp fire. It's time to get planning!
Spreading bonus money around rather than focusing on one objective is more effective and feels better.
Aren't you much better off now that you are caught up on bills, you've paid down some debt, established an emergency reserve, set aside some for retirement and college, and have a vacation plan in the works? If you had paid down all your debt with the bonus, leaving nothing for a rainy day fund, it's not going to help when the next emergency happens and you have to rack up more debt to cover it. Likewise, saving all of it in a 401(k) or other retirement account may mean nothing left to pay down credit card debt, which is dragging your budget down far more than investing in the stock market for retirement is helping your bonus dollars.
It's better to identify your priorities and fund each of them with any windfall. If you aren't caught up on bills and you owe high-interest debt, focus on accomplishing those first. Only then are you freed up to save, invest, and reward yourself with a little something. Now that sounds like a plan.