You’ve worked hard all year for that much anticipated year-end bonus. You’ve finally been informed of that magic number you’ll receive as a bonus, but then what? It may seem that by the time it hits your bank account, a good portion of it has disappeared. Some just expect to see only half the bonus amount. So where does it all go? Let’s break it down:
Taxes: just like how taxes come out of your paycheck, you’ll also be paying taxes on your bonus check. Specifically, your employer will withhold 6.2% for social security tax and 1.45% for Medicare tax. This is the same amount that comes out of your paycheck, so that shouldn’t be a huge surprise.
Additionally, federal and state income tax is also withheld from your bonus (which also shows up on your W-2 at the end of the year under other taxable salaries and wages). To withhold this tax, your employer has two options:
- Aggregate Method: where your income tax is calculated as if your bonus was added to one of your paychecks, or
- Flat Percentage Method: where your employer will withhold a flat 22% (in addition to the social security tax, Medicare tax and any state income tax dependent on your state). An example provided by Intuit: if you receive a $6,000 bonus, you’ll have 22% or $1,320 withheld for federal taxes. Note, this rate goes up if a very large bonus is received – over $1 million, in which the rate goes up to 37%.
Note, one method or the other doesn’t necessarily mean you’ll pay more for taxes, as it will even out once you file your tax return. You may get more money back or owe more depending on your situation, bonus check included.
Retirement: another element of your bonus that’s often overlooked is any automatic contributions to your 401k account. These will often still come out of your bonus check, so be sure to check how your company handles this type of contribution. If you’re contributing 10% to retirement, that could be a big chunk of your bonus (but keep in mind, it’s also being applied to your future, which isn’t a bad thing).
In addition, you could even be saving on taxes when using your bonus check to contribute to your 401k account. With a traditional 401k, you’re putting pre-tax money away so you’re avoiding those upfront taxes. Plus, any tax on investment gains is deferred until you retire so more of that money will be available to grow over time. Some employers will offer a match incentive, so ensure you max out the company match to avoid leaving any money on the table.
Now that you understand how you arrived at your net bonus amount, how should you use those “extra” funds? Before going on that shopping spree, consider these 3 options that can help your future financial self, both this year and beyond:
- Pay off your Credit Cards: any high-interest debt can be a downward spiral. Consider using your bonus to make a dent in any credit card debt, especially toward those cards with the highest interest rate. If you went a bit overboard during the holidays, now is the perfect time to get those credit card balances under control as you start off the new year.
- Build up your Emergency Fund: that pesky emergency fund may seem stagnate if you don’t have a formal plan to help grow it. Using your bonus money to get your emergency fund in a good spot can help ensure you’re able to respond to any unexpected expenses that may pop up in the future.
- Invest in your Future: although you don’t get that instant gratification, investing is a smart strategy to use all, or even a portion, of your bonus funds. Whether you choose to apply it to an index fund for yourself or a 529 plan for a child’s future education, investing money now will give those funds more time to grow for an even bigger bonus to your future self.
Although your bonus is certainly well-earned, it’s important to treat it as a building block for financial success. The phrase, “don’t spend it all in one place” can be especially relevant when you receive that bonus check. Perhaps treat yourself to a little indulgence, and then use the rest of the funds to help your financial health. After all, what better time of the year to set yourself up for success than the start of a new decade.
You can always invest in CDs and make your money work for you in 2020. Check out our current rates.