Every year, industries such as investment banking pay large annual bonuses. Often times these bonuses can range from 1 to 2 times salary or higher.
Due to these large lump sum payments, it’s important to have a plan in place each year regarding the best use of the funds. Below is a general guide that illustrates some of the many financial and tax planning strategies available.
Income Tax Projection – Set aside funds for taxes
First and foremost, complete an income tax projection to know if you should immediately set aside a portion of the proceeds for next April or for quarterly estimates if needed. If there is a gap, it may be wise to discuss future bonus withholding with HR to ensure your don’t get caught empty handed. Form W-4, which sets the withholding, may need an update as your life evolves (buying house, marriage, kids, etc.).
Also, for those receiving restricted stock units as a part of their bonus, don’t forget to include any previous year vesting in your tax projection and to track when stock will vest years into the future.
Fun Forecasting – Enjoy your hard work!
You worked hard for your bonus. Don’t forget to treat yourself, or set aside some funds for your personal enjoyment.
Emergency Fund – 3 to 6 months of cash flow
Bonuses are a great source for your emergency fund. Revisit your monthly expenses annually and ensure your emergency fund covers 3-6 months. For single income households, 6 months is often suggested.
Open a separate interest bearing savings account at an FDIC insured bank. Do yourself a favor and name it your “Emergency Fund” and behaviorally you’ll be less inclined to reach in unless it’s truly an emergency.
Debt – Pay it off!
Many high earners come out of graduate school with several hundred thousand dollars of student loan or other debt. Current loan rates and consolidation rates are north of 5 or 6%, therefore it often makes sense to plan an accelerated payoff strategy. This is especially true if your income bracket precludes you from taking a tax deduction on the interest.
Think of it as guaranteeing yourself a return on investment (i.e. your student loan rate) versus the alternatives of investing with no guarantee on the return or spending it all.
Unless you’re looking to be free and clear of debt as soon as possible, it often makes sense to balance the tax deferral strategies listed below with your debt payoff strategy.
Paying off all high interest credit card debt should be a top priority.
401(k) – Max it out!
The limit for 2015 increased to $18,000 ($24,000 if your 50+), so don’t forget when you get your raise annually or at bonus time to make sure your contribution percentage will max out the plan for the year.
Spouse’s 401(k) and Other Retirement Plans – Max it out!
If your spouse has access to a 401(k) and/or deferred compensation plan such as a 457, it’s not a bad idea to rearrange family cash flow so that your spouse takes full advantage of these tax deferral options.
For example, a spouse may have access to, but is not be maxing out, their 401(k) or 457 plans. Save money from the bonus for operating cash flow and increase the spouse’s payroll contributions in order to max out the 401(k) and 457 plans. This allows the family unit to defer tax on a tremendous amount of income.
Health Savings Accounts – Max it out!
Many employers are now offering high deductible health plans that are combined with a health savings account. If a high deductible plan makes sense for you and your family’s health situation, this is one of the best tax deferral mechanisms available.
For 2015, the limit for a family is $6,650 or an individual is $3,350 (add $1,000 if you’re 55 or older). Use your bonus or annual raise to ensure you’re maxing out this “medical IRA.”
Instead of using these funds for annual medical expenses, pay out of pocket and invest the HSA funds like a retirement IRA. After age 59.5, the investments will likely have grown and can then be used for either medical expenses (not taxable) or for regular living expenses (taxed like a normal IRA in retirement).
529 Plan Funding – Start funding your children’s education
Most states sponsor a tax-preferred account that includes federal and state tax preferences and often times additional state tax deductions. All investment growth is tax free if used for qualified education purposes.
So not only are you saving for your child’s education, but you’re also getting a tax break as well.
Example: In Virginia, if you have 2 children, start 4 separate 529 plan accounts. Have each spouse create an account for each child and contribute $4,000 to each account. You’ll receive a $16,000 deduction (not credit) on your Virginia tax return and the growth on the accounts won’t be taxed if it’s used for qualified education purposes.
IRA Funding – Max it out!
For 2015, the limit for an individual is $5,500 (add $1,000 if you’re 50 or older). While most folks in the higher income brackets don’t receive a deduction for their contribution, the account grows tax deferred until funds are used in retirement.
Roth Conversion – Best planning move available to high earners!
A Roth IRA conversion can be a bit tricky, so enlisting the help of a qualified CPA is suggested. If the situation is right, often times one or both spouses can convert their traditional IRA contribution to a Roth, never to be taxed again (under current law).
There are several things to be aware of when choosing this powerful strategy, so again, tread carefully if you go it alone.
As you can see, there are tremendous amounts of planning strategies available to high earners during bonus season. Use this as a checklist annually and you’ll be on the right track.
About Atlas Financial
Need help implementing these and other financial planning or tax strategies? Atlas Financial is a full service personal financial planning firm that provides affordable fee-only financial planning, investment, and tax advice to hard working professionals. Give us a call (804) 557-0903 or send us an email today firstname.lastname@example.org