Great news! You just found out that your new job has a signing bonus. Or perhaps you met with your current boss and found out that you have been promoted and will be receiving a raise. Or maybe you’re expecting a big tax refund this year. Whatever the case may be, there are a number of opportunities for you to come into an unexpected windfall.
So how can you put those extra funds to work? Jumping on the next flight to an exotic location sounds pretty good to me! All kidding aside, there are actually many ways to utilize this additional income to positively affect your financial situation (as good as a vacation or extra spending money may sound).
Let’s take a look at some options available to you:
Pay Down Debt
Like many people, you may have mortgage debt, student loan debt or even credit card debt. If you receive a windfall or a bonus, one of the best things you can do is pay down or pay off some of these debts. Paying off debt, especially debt with high interest rates, can help you shape a positive financial picture.
Credit cards typically come with the highest interest rates, so you should focus on paying off those debts first. By applying a lump-sum payment to your bill, you can reduce your current and future liability to the credit card company.
While your bonus may not be enough to pay off your loans or mortgage entirely, boosting your payment for just one month can have a positive impact over the long term.
The amount that is paid over your minimum payment may be applied to the principal balance of the loan, not interest; this means you will be successfully paying down the amount that you borrowed, which can reduce your interest payments over time.
In general, it’s a good idea to boost your debt payments gradually each month, which might be more feasible if your bonus is in the form of a raise. Interest payments can really add up over time; the sooner you can pay off your debt, the less interest you will pay.
Contribute to an Emergency Fund
Are you financially prepared for the unexpected? If not, your bonus presents the perfect opportunity to kick-start your emergency fund. The rule of thumb is that you should have a cushion of three to six months’ worth of liquid assets to cover a range of events, from medical bills to car trouble to potential unemployment. Evaluate your current financial situation and determine whether you have a sufficient savings reserve, should you face any emergency expenses.
You may already have a significant cushion of investment assets set aside — and that’s great! However, you should not count those assets toward your emergency fund.
Pulling money from your investment accounts can potentially generate capital gains and lead to taxable income. It’s important that your emergency fund is stored in an account that’s easily accessible and ready to be tapped for immediate needs; a basic savings account or a money market savings account are both great options.
If you received a raise, set a savings goal and get into the habit of contributing that extra portion of your take-home paycheck into your emergency fund. Before you know it, you’ll have a healthy cash cushion saved up.
Increase Your Retirement Savings
Consider putting your bonus to work for your retirement by contributing to an individual retirement account (IRA). You can either contribute to a traditional IRA or a Roth IRA. Depending on your income, a Roth IRA can be a viable savings vehicle, because it allows for your assets to grow tax-free. The best part? Once you reach age 59 ½, distributions you take from the Roth IRA account can be tax-free, as well!
If your taxable income exceeds the income-eligibility limits for Roth IRAs, you may consider contributing to a traditional IRA. You can contribute to these vehicles with pre-tax dollars, which can provide you with immediate tax savings. However, unlike the Roth IRA, distributions from the account are taxable; you are essentially deferring the tax payment to years in the future.
If you’re married, you can also contribute up to $5,500 ($6,500 if you’re over age 50) to your spouse’s IRA, if you file as married filing jointly for tax purposes. A benefit to this provision is that even if your spouse has no income for the year, you can still make a contribution on their behalf, so long as your household taxable income is more than $11,000 ($13,000 if you’re over age 50).
Another way to increase your retirement savings — especially if you’ve received a raise at work — is to maximize your contributions to your 401(k) or another employer-sponsored retirement plan. Not only can this help you collect additional retirement savings, but it can also help you reduce your taxable income (if you contribute pre-tax dollars), which can have a significant impact on your tax liability, depending on the amount of your raise.
Contribute to a Taxable, Non-Retirement Investment Account
Contributing to a retirement account isn’t the only way to get involved in the stock market; you may also consider opening a new, taxable investment account. Many people use this type of account to save for a significant life event, such as purchasing a home, getting married or starting a family, because you can withdraw the funds at any time — no need to wait until 59 ½. If you opt to apply your bonus to this type of account, a financial advisor can help you complete a risk assessment and determine an appropriate asset allocation based on your goals, risk tolerance and time horizon.
Setting aside at least part of your hard-earned bonus to one of the options above can help put you in a strong financial position as you head into the New Year. And if you do find yourself in a good financial situation with minimal debt, significant retirement savings and a healthy emergency fund, there is nothing wrong with spending a little bit of your bonus on yourself — you’ve earned it!