By weighing the tax implications and your long-term goals, you can make your bonus go further.
A tax-advantaged account like a 401(k), IRA, or HSA may make for an effective home for your bonus.
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) for 2019, 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 2019 is $19,000 ($25,000 if you’re 50 or older). You can choose any combination of pre-tax or Roth contributions as part of your $19,000/25,000. 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 Alex Benke 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.
According to a Forbes report, if you’re under 50, earning $240,000 and deposit $18,500 in your 401(k) by April 15, you’d get about $2,100 from your employer’s match (assuming a match of 50% up to 6% of contributions). But if you spread out your contributions over the year, you could earn over $5,000 more in employer matching funds. 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 $2,700 for 2019), a health savings account (the maximum for a family is $7,000 for 2019), 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.
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.
How to Do a Direct IRA Transfer
A transfer of your IRA to Betterment is easy and can be done online in four simple steps.
Married Filing Separately: Marriage Tax Benefit or Penalty?
If you’re married, deciding how to file your taxes—jointly or separately—may make a difference in how much you pay. Here’s what you need to consider.
The Difference Between Vanguard and Betterment
I’ve been asked a lot in the last few months in the transition from my old role at Vanguard to my new role as Chief Growth Officer at Betterment – what’s the difference between the two companies?
Explore your first goal
This is a great place to start—an emergency fund for life's unplanned hiccups. A safety net is a conservative portfolio.
Whether it's a long way off or just around the corner, we'll help you save for the retirement you deserve.
If you want to invest and build wealth over time, then this is the goal for you. This is an excellent goal type for unknown future needs or money you plan to pass to future generations.
How would you like to get started?
Your first step toward a smarter investing future starts here.
Create a Betterment account
Go ahead and join the smart, modern way to invest.
See what we can do for you
Tell us a bit about yourself, and we'll show you the benefits of investing with us.
Get a free investing checkup
Help us get a sense of your investing approach and see how you could improve.
Transfer a 401(k) or an IRA
Move an existing retirement account into a Betterment IRA.
Download the mobile app
Enjoy the Betterment experience anywhere on the go.