Five Tips to Make Your Money Work for You
You were recently awarded a bonus – fantastic! Now what? You have an opportunity to decide whether you will use that “extra” money to pay down debt, add to your savings and/or investments, or spend on something fun. The following tips can help you maximize the benefits of your bonus.
Tip #1 – Consider your tax planning opportunities
Before you do anything else, consider the tax implications of your bonus. Depending on your bonus amount, the implications can be significant; however, there are several ways to reduce your tax liability. If the bonus amount is enough to push you into a higher tax bracket, you may want to consider deferring the bonus to the next calendar year, if this is an option. Also, if you donate to charities each year, you may consider establishing and funding a donor-advised fund (DAF) with a portion of the bonus.
Tip #2 – Emergency planning should be your first priority
While paying down debt is an important consideration, it should not take priority over establishing an emergency fund of at least three to six months’ worth of expenses. As we’ve seen all too clearly over the last year, anything can happen. It’s important to make sure your family’s needs are covered should you lose your job or be unable to work. Having an emergency account in place will allow you to continue to pay the bills in an unexpected situation.
Tip #3 – Say “yes!” to free money
After shoring up your emergency fund, make sure you are contributing enough to your employer-sponsored retirement plan to take full advantage of any matching contributions. Regardless of the amount of your employers’ match, it’s wise to maximize every cent.
Tip #4 – Pay down bad debt
Begin with a review of your current debt with an eye toward identifying “bad” debt. Bad debt is any debt that charges an interest rate higher than what would be considered a reasonable long-term rate of return from an investment, generally 6 to 8 percent. If you carry bad debt, such as a credit card with an 18 percent interest rate, use as much of your bonus as possible to pay it down or (hopefully) pay it off. Start with the loans that carry the highest interest rates. If necessary, consider using some of your emergency funds to pay them down. If you have an emergency before you have a chance to replenish your emergency account, you can resort to using the credit card again if necessary, while saving considerable money on interest payments in the meantime.
Tip #5 – Decide whether to save or spend
After building your emergency fund and knocking out bad debt, you get to make a fun decision. Will you save the bonus or spend it? Ultimately, the art of financial planning is in finding a healthy balance between what you spend today and what you save for future spending. Let’s assume that, because you have a financial plan in place, you know that you are not yet on track to meet your goals. Your bonus, especially if you weren’t counting on it, is a great way to close the gap in your financial plan. Common ways to invest a bonus include a Roth IRA, traditional IRA, employer-sponsored retirement plan and other nonqualified investment accounts. Each account has different tax consequences and eligibility rules, but they are all powerful tools that can help you work toward your personal financial goals.
Roth IRA/traditional IRA
Contributions to a Roth IRA or a traditional IRA are limited to $6,000 in 2020 (an additional $1,000 catch-up contribution is permitted for those age 50 and older). It is possible to contribute to both a Roth IRA and a traditional IRA, but the combined contributions cannot exceed the limit. In addition, your ability to make Roth IRA contributions is reduced once your income reaches $124,000 ($196,000 for joint filers) and is eliminated once your income reaches $139,000 ($206,000 for joint filers). The most beneficial aspect of a Roth IRA is that distributions from the account during retirement are tax-free. In contrast, contributions to a traditional IRA can have the benefit of being tax-deductible (subject to income limits), but distributions from the account during retirement are taxable. Distributions from both types of IRAs prior to 59 ½ may be subject to a 10% early withdrawal penalty.
Employer-sponsored retirement plan
Similar to Roth IRAs and traditional IRAs, employer-sponsored retirement plans have contribution limits ($19,500 or $26,000 if you have reached age 50). Employer-sponsored plans allow you to make pre-tax contributions, which, like a traditional IRA, will reduce your taxable income now but the distributions will be taxable when they are withdrawn. In addition to pre-tax contributions, some retirement plans allow you to make after-tax contributions. If you take advantage of these contributions, then you give up the tax deduction now, but you will not need to pay taxes when the contributions are distributed in retirement.
Nonqualified investment account
Another savings option for your bonus is to establish a nonqualified investment account. A nonqualified investment account provides no tax-deferral benefits. Instead, you will be responsible for taxes as your investments pay interest and dividends, or when you sell investments for a profit. While you are paying taxes annually, it is likely that the tax rate is less than your ordinary income tax rate, and you will not be subject to penalties if you withdraw from the account before you reach age 59 ½.
As with most things in life, the key to savvy financial planning is in finding balance. It’s important to balance what you spend today and what you spend tomorrow. Once you are comfortably on track to meet your long-term goals, make sure to enjoy some of your bonus now. “Fun” expenditures may include, for example, a vacation or a home improvement project. While home renovations don’t always increase the value of a home by the amount spent on the project, they can be a great source of personal enjoyment. On the other hand, if you’ve been burning the candle at both ends for a little too long, consider taking the vacation of your dreams. Tahiti, here you come. Bon voyage!
At Creative Planning, we help clients achieve a comfortable balance between saving for the long term and enjoying life today. Our advisory teams work with clients to develop personalized financial plans that take into consideration a wide range of factors, including their current financial situation, goals for the future and any challenges they may face. If you’d like to have a conversation with one of your experienced advisors, please contact us.