How to Divide Your Bonus: Save or Spend? And Don’t Forget to Plan for Taxes

You just got your bonus check. Congratulations!

Now, like many people, perhaps you’re wavering between being practical (paying bills, investing, and saving toward your goals) and splurging on some of your wants. But it doesn’t have to be an either/or proposition.

Although everyone’s finances are different, it’s generally a good idea to use your bonus to pursue long-term goals, such as retirement, but also enjoy some of the money. With a little planning, it’s possible to invest your bonus and figure out the best ways to spend your bonus.

What to Do with Bonus Money: Consider Dividing Your Bonus

To start, consider treating your work bonus like a paycheck. You’ve likely earmarked a certain percentage of your pay for expenses, savings, and discretionary spending based on your goals and financial needs. You can use this same approach for your bonus.

For example, if you’re trying to pay down debt, you might allocate 50% of the money for that, 30% for savings, and 20% for spending. But if you feel your debt situation is at a manageable level, you might invest a chunk into a 401(k) plan or Individual Retirement Account (IRA). Or, if you’re already contributing the maximum allowable amount to your retirement accounts, you might up the percentage earmarked for other goals.  

Keep in mind there’s no right or wrong way to divvy up the funds. Look at your budget and financial plan to help figure out what save-or-spend breakdown makes the most sense.

Identify and Prioritize Your Goals

Bonus money earmarked for expenses and savings is often used to pay bills or to boost an emergency fund. But if you already have these basic needs covered, your bonus check becomes a way to help move forward on your financial journey. Here are some possible ideas for how to spend your bonus.

Are you hoping to pay off your home before retirement? Using a portion of your bonus to make an extra payment is one way to make progress on this goal and save money.

For example, an additional one-time $2,000 payment on a $200,000 mortgage could knock three months off the loan and save approximately $1,400 in interest, which you could put toward other goals. Doing this each time you receive a bonus may help you pay off your mortgage even faster.

Many credit companies have limited-time deals where you can transfer or consolidate your balance at low to no interest. If you typically carry a credit card balance from month to month, you may want to take a closer look at these offers. It could be a way, along with using some of your bonus money, to help pay off your debt sooner.

Hoping to have a vacation home or travel abroad? The bonus dollars you put away today could help make these dreams a reality. You could even figure out how to invest the bonus in a way that allows you to reach your goals faster.

Consider setting up a separate account to save for these goals to help minimize the temptation to use the money for something else.

If you’re participating in a high-deductible medical plan, you might be able to put some of your bonus in a health savings account. Contributions are generally tax-deductible and you can usually withdraw money tax-free for qualified medical expenses now and in retirement.

For 2020, individuals can contribute up to $3,550 ($7,100 for families) to an HSA. If you’re 55 or older, you can contribute an additional $1,000. Health care is one of the largest expenses you’re likely to incur. Having an HSA to help cover these costs could potentially free up your savings for other things.    

According to the College Board, the average cost for tuition and fees and room and board at an in-state, four-year college was over $21,950 for the 2019–20 school year. And this figure will likely go up. Consider giving your loved ones a helping hand by putting some of your bonus in a college savings plan for them. Every little bit helps and your contribution could potentially reduce the need for student loans. 

Be a Savvy Spender

Figuring out what to do with bonus money allocated for spending is the fun part. As you make your wish list, look for ways to make the most of your shopping. If you have a credit card that offers rewards such as cash back or air miles, consider using it for your purchases. Then pay the balance off with your bonus to help avoid interest charges. Any rewards you earn are another bonus that could help you get something else you want.

Don’t limit your list to just material goods. Think about experiences you want to have—perhaps visiting a new city, taking a cooking class, or learning how to sail. The memories you create are priceless and may bring you joy for years to come.

Plan for Taxes

As you decide what to do with bonus money—including whether to save or spend—it’s important to plan for taxes. If your windfall has been labeled as a bonus, the IRS will see it as “supplemental wages” and your employer will need to withhold 22% of the amount paid. So, even though you might be told you’re getting a certain bonus, the amount that appears in your bank account will be smaller. Don’t make plans for what to do with your bonus money until you see the final amount.

Be aware that your bonus could push you into a higher tax bracket. Consider talking to a tax professional to determine how to reduce your tax bill. Some ideas for reducing your taxes when you receive a bonus include:

• Donating to charity. In 2020, you get an above-the-line deduction for up to $300 in donations to charity. If you itemize, your charitable donations above that amount could be even more helpful.
• Making another tax-advantaged contribution. Depending on your goals and the contribution room you have left, you could invest your bonus in a tax-advantaged account like a traditional 401(k), IRA, or HSA. This could mean a reduction in your taxable income, partially offsetting your bonus.
• Pre-paying next year’s deductible expenses. If you have deductible expenses coming up, like utility bills for your home office or the need for a new work computer, you can pay for these items before year end and add them to your tax deductions.

Bottom Line

You worked hard to earn your bonus check and deserve to treat yourself. But remember to consider your future self by splitting the money between your expenses, savings, and spending—and don’t forget to plan for taxes. It’s important to balance current needs and wants with long-term goals.