How to Use Your Bonus Wisely to Get a Tax Break
Bonuses are tricky. Here's how you can make your bonus work harder for you by reducing the tax impact.
How are you planning to spend your annual bonus? Like with any cash windfall, we all want to use it wisely. But bonuses can be tricky because of taxes.
To use a bonus most tax-efficiently, you’ll need to juggle multiple objectives and concerns.
If you’re expecting to get more than one bonus per year, it’s important to consider all of the possible ways to invest a bonus to maximize its potential value. In this article, we’ll review how bonuses are typically taxed, what factors you should be aware of, and how to take advantage of different accounts and investing strategies to make your bonus work harder for you.
How Does a Bonus Get Taxed?
Bonuses are considered “supplemental income” by the IRS, which means they could be withheld differently than your regular salary.
The IRS suggests a flat withholding of 22% from bonuses, and many employers follow that method. (Remember that withholdings are meant to be an estimate of how much you’ll owe at the end of the year, not the actual tax itself.) But some employers use the aggregate method, in which your whole bonus is added to your regular paycheck, and the combined amount is withheld at the normal income rate, as though that amount is representative of what you make every paycheck, which could be higher (or lower) than 22%.
Some people believe that bonuses are taxed at a higher rate than ordinary wages, but that’s not the case. The aggregate method of withholding can result in bumping you into a higher estimated tax bracket, which creates the illusion that you “keep less of it,” but no special tax rates apply just because a payment from your employer is characterized as a bonus. A bonus is like a raise, but when your income goes up, it could do more that just move you to a higher tax bracket—you could potentially lose certain deductions and tax credits.
Bear in mind, while we hope you find this information helpful, you should consult a tax professional to understand your individual circumstances. Betterment is not a tax advisor, so while we like to offer helpful information to get you started, this should not be considered tax advice.
With that said, here are some simple suggestions for how you can use tax-deferred or even taxable accounts to help preserve and grow your windfall.
1. Boost Your 401(k)
Before you add your bonus to your 401(k), check with your employer about how bonuses are handled. In some cases, your company may not allow you to make 401(k) contributions using your bonus.
In others, your 401(k) plan may be set up to withhold the same percentage from your bonus as from your paycheck. Thus, if you typically contribute 10% from every paycheck to your 401(k), that same amount could be withheld from your bonus (unless you say otherwise). In the case of a $15,000 bonus, $1,500 would go into your 401(k), which may be too little for your aims.
The Max Contribution Limit for a 401(k)
Of course, you can’t contribute more than the annual limit, so be sure to check how much you’ve contributed for the year to date. The contribution limit for your 401(k) for 2020 is $19,500 ($26,000 if you’re 50 or older). You can choose any combination of pre-tax or Roth contributions as part of your total contribution limit.
Not sure which type is good for you? Many participants “split the difference” and contribute 50% pre-tax and 50% Roth. To figure out what kind of contribution might work well for you, use Betterment’s traditional vs. Roth 401(k) calculator.
Also, don’t assume that a lump-sum deposit is best, especially if your employer matches your 401(k) contributions. A single large deposit might not get the same amount of matching dollars that a comparable amount would if you spread the deposits over time. Betterment’s resident CFP® professional Nick Holeman notes that it depends on your employer’s matching structure. Certain plans offer a “true-up” for matching contributions if you max out early in the year while many plans do not offer that feature.
Talk to your employer to find out exactly how they calculate the match.
2. Take Advantage of Multiple Accounts
Now here’s the part you may not be aware of: depending on your income and whether you or your spouse is participating in a company retirement plan, you might be able to reduce your taxable income further by contributing to your flexible spending account this year (the maximum is $2,750 for 2020), a health savings account (the maximum for a family is $7,100 for 2020), and a traditional or Roth IRA.
Many people don’t realize that you can participate in a company plan and still fund a traditional or Roth IRA. You could contribute to your 401(k) this year, and contribute to a traditional or Roth IRA as well, or a combination of those.
As the IRS notes: You can contribute to a traditional or Roth IRA whether or not you participate in another retirement plan through your employer or business. However, you might not be able to deduct all of your traditional IRA contributions if you or your spouse participates in another retirement plan at work. Roth IRA contributions might be limited if your income exceeds a certain level.
3. Invest in a “Happiness Annuity”
If it’s not possible or advantageous to put your money only into tax-deferred accounts, use your windfall to invest by creating “a gift that keeps on giving.” You could spend it all, sure, but by investing your windfall in a well-diversified portfolio, you can create an additional source of cash flow that steadily adds to your quality of life, year after year: i.e. a happiness annuity.
Studies show that steady cash flow increases often feel better than a lump sum that’s here today, spent on the Canary Islands tomorrow.