Managing Bonuses and Other Year-End Income

At the end of the year, some people receive year-end bonuses or other extra income from employers. While a year-end bonus can feel like a windfall, it's essential to handle it wisely. A bonus can allow you to supercharge your savings, pay down debt, or work toward other financial goals.

Before deciding how to allocate your year-end bonus, it's essential to understand the impact this income can have on your tax bill. Year-end bonuses are generally taxed as supplemental income, which may be subject to a different withholding rate than your regular salary. The IRS typically withholds 22% of bonus income, so if you're in a higher tax bracket, you may owe additional taxes at filing time.

Consider setting aside a portion of your bonus to cover any extra tax liability, especially if the bonus pushes you into a higher tax bracket. Using a tax calculator or consulting a tax professional can help you estimate your tax obligations more accurately.

Prioritizing Financial Goals

A bonus provides a unique opportunity to boost your financial goals. Instead of spending it all at once, consider prioritizing long-term financial stability by allocating your bonus across several key areas.

Reducing Debt

Using your bonus to pay down this debt can provide immediate relief and long-term savings if you carry high-interest debt, such as credit card balances or personal loans. The faster you eliminate high-interest debt, the less you'll pay in interest over time.

Growing Your Emergency Fund

Also, if you don't have an emergency fund or your current fund isn't sufficiently funded, using part of your year-end bonus to build it up can provide extra financial security. An emergency fund should ideally cover three to six months of living expenses, giving you a cushion for unexpected events like job loss, medical bills, or home repairs. But even a small emergency fund can help avoid unexpected debt.

Contributing to Retirement Accounts

Maximizing your retirement savings is another smart way to use your year-end bonus. If you haven't yet reached your 401(k) or IRA contribution limits, adding to these accounts can reduce your taxable income for the year while helping you build wealth for the future.

Investing for the Future

Beyond boosting traditional retirement accounts, a year-end bonus can be a powerful tool for investing. If you're already maxing out tax-advantage retirement accounts, consider other investment options to grow your wealth over time.

Brokerage Accounts

Investing your bonus in a brokerage account allows you to buy stocks, bonds, mutual funds, or ETFs. Unlike retirement accounts, brokerage accounts don't have contribution limits, so you can invest as much as you want.

College Savings Plans (529 Plans)

If you have children or plan to support a loved one's education, you can also use your year-end bonus to contribute to a 529 plan. These tax-advantaged accounts allow you to save for future education expenses, and withdrawals for qualified education costs are tax-free.

Minimizing Tax Impact on Bonuses

In addition to setting aside funds to minimize your tax liability, there are other strategies you can use to reduce the tax impact of your year-end bonus. Always consult with a tax advisor before making decisions with the intention of reducing taxes - there may be other implications at both the federal and state levels that we can't cover here.

Increasing Retirement Contributions

As mentioned earlier, contributing to a 401(k) or IRA can help reduce your taxable income. By making larger contributions before the end of the year, you can lower your income subject to taxes, which is especially helpful if your bonus pushes you into a higher tax bracket.

Timing Your Bonus

The availability of these options depends on your employer's policies, but here are a couple of ideas. First, if you expect to earn less next year, deferring your year-end bonus to January may make sense. That way, you minimize taxes paid in your highest bracket.

It may also be possible to split your bonus into two payments - one in December and another in January - to avoid being pushed into a higher tax bracket if your income will be similar next year.

Again, the availability and utility of these approaches depend on your employer and your personal tax situation.

Adjusting Your Withholding Amounts

Suppose you regularly receive bonus income and your tax bracket exceeds the 22%. In that case, you can ask your employer to increase withholding from your regular paycheck to avoid owing taxes at filing time. While this approach doesn't reduce your bill, it helps to prevent surprises when filing (and perhaps underpayment penalties).

Tax-Loss Harvesting

If an investment in a taxable brokerage account has lost money, you can sell it and use up to $3,000 of the loss to offset ordinary income, including bonus income.

Do You Itemize Your Tax Decusions?

If you itemize deductions (versus taking the standard deduction), it may be possible to pre-pay tax-deductible expenses like mortgage interest and state / local taxes (SALT) up to the $10,000 SALT maximum.

Further, those who itemize their deductions can reduce tax liability by making charitable donations. If you've been considering donating to a nonprofit or charity, using part of your bonus to do so can provide tax deductions while supporting a cause you care about.

The Takeaway

While a year-end bonus can feel like a windfall, it's important to consider the tax implications and strategize accordingly. Setting aside funds for taxes, increasing pre-tax contributions, or exploring options like deferring part of the bonus can help minimize the impact on your tax bill.

Beyond taxes, a bonus offers a chance to grow your wealth, whether through retirement accounts, investments, or funding a 529 plan. With a clear plan, your bonus can become a tool for financial stability and long-term growth.