People who put their bonuses into retirement funds may be penny wise, but pound foolish. The market is volatile and your investment could lose a lot of its value before you retire. Plus, the current tax laws give you more opportunity for profit in other places with lower taxes like stocks or cash accounts.
You should really put your bonus into your retirement fund. The “should you change your 401k contribution for bonus” is a common question that comes up. It’s important to know the answer to this question before making any changes.
You’re not alone in asking what to do with extra money. Putting your bonus money into a tax-advantaged retirement plan, such as a 401(k), provides some real benefits. Not only will the additional income help you increase your savings, but you may also be eligible for tax breaks.
Of fact, we live in a society where financial priorities conflict. You may alternatively use the money to pay off debt, buy something you need, invest for a short-term objective, or indulge! The variety of options might be thrilling, but if a secure future is your main priority, a 401(k) bonus deferral should be considered.
Before you make a decision, consider the following tactics.
Related: Which is better for you: IRA or 401(k)?
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Getting a Bonus Payment
First and foremost, a practical reminder. It’s possible that the bonus check you get will not be in the amount you anticipated. This is due to the fact that bonuses are taxed. Knowing how your bonus is taxed will help you figure out how much money you’ll have left over and what you should do with it. Bonuses are treated as additional pay by the IRS rather than regular wages.
Your employer ultimately selects how to handle tax withholding from your bonus. Employers are allowed to deduct 22% of your bonus for federal income taxes. However, some businesses may include your whole bonus in your regular payment, taxing the bigger amount at regular income tax rates. You may pay more in taxes than you planned if your bonus puts you in a higher tax rate for that pay period.
Furthermore, your bonus may be included in your paycheck rather than as a separate payment, which might be confusing.
Whatever the ultimate amount is or how it comes, be sure to put aside the whole sum while you consider your alternatives – otherwise, as behavioral finance research has shown, you may be tempted to spend it.
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What Should You Do With Your Bonus Money?
There’s nothing wrong with spending part of your hard-earned pay bonus. One rule of thumb is to spend a portion of any windfall (e.g., 10% or 20%) and preserve the remainder, whether it’s a bonus or a birthday check.
Many individuals choose a 401(k) bonus deferral and deposit part or all of their bonus into their 401(k) account to get the most out of their bonus. The amount of your bonus you opt to donate is determined by how much you’ve previously given and if it’s tax-wise.
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1. Making a 401(k) contribution (k)
In 2022, the 401(k) contribution maximum is $20,500; those 50 and over may put additional $6,500, for a total of $27,000. If you haven’t yet hit the cap, putting a portion of your bonus into your retirement plan will help you save more for retirement.
If you’ve already reached your 401(k) contribution limit, your bonus may enable you to invest in an IRA or a non-retirement (taxable) brokerage account.
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2. Making an IRA contribution
You may still be eligible to start a regular tax-deferred IRA or a Roth IRA if you’ve reached your 401(k) contribution limit for the year. It is determined by your income.
The contribution ceiling for regular and Roth IRAs will be $6,000 in 2022, with a $1,000 catch-up provision for those over 50. You can’t contribute to a Roth if your income is beyond $144,000 (for single filers) or $214,000 (for married filers filing jointly). While a standard IRA has no income restrictions, if you have a 401(k) plan at work, the situation changes (k).
You won’t be able to start a regular, tax-deductible IRA if you’re covered by a job retirement plan and your salary is too high for a Roth. However, you may start a nondeductible IRA. You may wish to get advice from an expert to better appreciate the differences.
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3. Making a taxable contribution
Of course, when you’re weighing What Should You Do With Your Bonus Money?, you don’t want to leave out this important option: Opening a taxable account.
While employer-sponsored retirement plans often have certain limits on what you may invest in, taxable brokerage accounts provide you more flexibility. If your 401(k) is full and an IRA isn’t an option, you may use your bonus to invest in stocks, bonds, exchange-traded funds (ETFs), mutual funds, and other taxable investments.
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4. Compensation Deferred
Deferring compensation may also allow you to preserve portion of your bonus from taxes. This is when a portion of an employee’s pay is withheld and distributed later to offer future tax advantages.
In this case, you might put away a portion of your salary or bonus to be reimbursed later. When you postpone income, you must still pay taxes when you get it later.
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Tax Breaks on Your Bonus and 401(k)
Are you unsure what to do with a bonus? It’s an excellent question to pose. You want to minimize your taxes as much as possible in order to maximize the value of your bonus.
Putting a portion of a bonus into a tax-deferred retirement plan like a 401(k) or regular IRA is a common way to decrease income taxes. The money you put into these accounts often lowers your taxable income in the year you deposit it.
This is how it goes. The money you put into a 401(k) or conventional IRA is tax deductible, which means you may deduct it from your taxable income, decreasing your tax burden. (This is not the case with a Roth IRA or Roth 401(k), where contributions are made after taxes.)
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Limits on annual contributions
The Limits on annual contributions for each of these retirement accounts noted above may vary from year to year. Depending on the size of your bonus and how much you’ve already contributed to your retirement account for a particular year, you may be able to either put some or all of your bonus in a tax-deferred retirement account.
Because you don’t want to put too much of your bonus into your retirement accounts and exceed the contribution limit, it’s crucial to keep track of how much you’ve already placed into them. You may deposit portion of your bonus into other tax-deferred accounts, such as a regular IRA or a Roth IRA, if you have hit the contribution maximum.
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How Investing Your Bonus Can Benefit You in the Long Run
Investing your bonus may help you boost its long-term worth. As your money appreciates in value over time, you may set aside a portion of it for retirement, an emergency fund, a down payment on a house, paying off debts, or another financial objective.
While having part of your bonus in cash might be advantageous, your money is best served by being invested in a vehicle that works for you and does not lose value due to inflation. If you start putting your bonus into a tax-deferred retirement account or a non-retirement account each year, you’ll be one step closer to having more financial stability in the future.
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The Conclusion
The topic of what to do with a bonus arises every year. Simply possessing that windfall opens up a plethora of financial possibilities, such as saving for urgent necessities — or acquiring what you need right now. However, it may be wiser to spend your bonus to increase your retirement savings, for the simple reason that you may stand to earn more monetarily in the future while simultaneously receiving tax advantages now.
Because most individuals don’t max out their 401(k) contributions every year, it can make sense to take part or all of your bonus and “fill up the gas tank,” as it were. If your 401(k) is depleted, you may still save for the future via conventional or Roth IRAs, deferred compensation, or investing in a taxable account.
A taxable account may provide you with additional or alternative investment possibilities to fill out your portfolio.
Considering the tax consequences of where you invest may also assist you in allocating this additional cash to the greatest use for your plan.
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FAQ
Is putting your bonus into a 401(k) a wise idea?
Yes is the quick answer. Depending on how much you’ve previously contributed to your workplace account, you may choose to deposit part or all of your bonus into your 401(k). Make sure you don’t go over your 401(k) contribution limit.
How can I keep my bonus from being taxed?
Although your bonus will be taxed, you may reduce your taxable income by putting part or all of it into a tax-deferred retirement plan like a 401(k) or IRA. This does not, however, imply that you will be able to totally avoid paying taxes. Ordinary income tax will apply to the money you remove from these funds in retirement.
Is it possible to deposit my whole bonus into a 401(k)?
Possibly. If you haven’t hit your 401(k) contribution maximum for the year and aren’t going to exceed it by adding all of your bonus, you may put it all in. For 2022, the 401(k) contribution maximum for those under 50 is $20,500; those over 50 may contribute an extra $6,500 for a total of $27,000.
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