Working with numbers is why I got into this business. They make sense and, in a way, provide a semblance of order to life. Developing strategies based on solid math and established probabilities has great appeal for my analytic side.
However, it is the human interaction which has kept me in the business for over two decades. Humans are amazing, wonderful beings and I wouldn’t trade my experiences with my clients for anything. They have shaped my world view more than any spreadsheet or financial reports I have ever come across.
Others have shared with me that they enjoy people-watching in public places … a mall, workplace meetings, or the airport (where someone’s true nature tends to shine through). I maintain there is no better place to observe behavior than up-close, helping someone navigate financial decisions. At no point during these discussions are there more varied yet visceral reactions than to those surrounding ‘found money.’
‘Found money’ is just what you’d expect it to be: newly identified discretionary income, excess savings, inheritance, or an unexpected bonus at work. Emotions run the gamut during the discovery of additional funds. For many, the conversation transpires much like a sped-up version of the stages of dealing with grief:
Denial – We cannot have that much left over, unallocated … Can we?
Anger – I should have developed a plan for this long ago!
Detachment – Well, since things always come up, I will just leave this aside, knowing it’s there for a rainy day.
Bargaining – If I use some this money to update the kitchen, I promise to put the rest away in a mutual fund.
Acceptance – It’s never too late to plan and make appropriate financial decisions with the help of a knowledgeable advisor who understands the entirety of my situation!
While having a strong income (one which more than meets ongoing needs) is a huge benefit and there should be a plan for the excess which involves identification of less immediate goals and related investment, the rest of this blog will concentrate on the sudden appearance of lump sums. More specifically, we’ll weigh the options people have when getting a taxable bonus from the workplace.
Should your employer let you know a bonus is coming, you have two choices:
- Let the money get disseminated through payroll and make use of the after-tax amount
- Work with your Payroll Department to defer the receipt of some, or all, of the proceeds
The advantage of the first option is obvious. You’ll have more money in your pocket and you’ll be able to procure more goods and/or services. Spending, especially when done locally, helps the economy thrive. And, it’s nice to treat yourself to something, once in a while. However, taking a vacation, buying a boat, updating your truck, or making cosmetic improvements to your home are only appropriate when the following ring true:
Consumer Debt is under control – Pay off all credit cards before incurring other large / indulgent expenses. Some credit cards charge 20% interest rates. If you use your bonus to pay down/off a credit card, you, essentially, get a definite rate of return on your money; this could be higher than the rate you’re attempting to achieve on your investments.
A Cash Reserve exists – Depending on your comfort zone, it is best to maintain a balance of 3 – 6 times your regular monthly expenses between your checking and savings accounts. This will help you avoid the use of credit for opportunities or emergencies we all experience throughout the year.
Your Long-Term Goals are appropriately funded – Most people spend more time planning one vacation than they do examining what a secure retirement looks like. Try not to spend additional receipts on the here and now if you have no idea what it will take to achieve financial independence or send your little ones to the right school.
… if these three things are in order, congratulations! You have money with which you can enhance your current lifestyle. That is … unless you are concerned about the increase to your tax liability your bonus represents.
Should your concerns lie with reducing current taxation and shifting federal and state assessments to a later date, when it is possible your income will put you in a lower tax bracket, you have limited choices for placement of those receipts.
The most popular option, in this case, is to defer all or part of your bonus to your workplace retirement plan (401k, 457b, 403b). Those under age 50 in 2017 can contribute up to $18k to their retirement accounts. Those attaining age 50 or greater during this calendar year can contribute up to $24k.* Most Payroll Departments now follow the Federal guideline that bonus payments are to be subject to mandatory 25% withholding for federal taxes. Contributing to your retirement plan could have 100% of your bonus invested toward your future while having the funds paid directly to you could see as little as 71% deposited in your account (4% withheld for state taxes in this example).
* A special addendum for those covered by 457b plans … you can contribute up to $36k this year provided that you are less than 3 years away from being able to take a full pension. So, any Public Safety professional with at least 17 years in PSPRS can use this option. Non-sworn personnel must get beyond 74 points in ASRS to use this “Pre-Retirement Catch-Up Provision.” When/if you choose to get involved with this option, you will be opening a 3-year window in which you can save up to $36k per year to make up for years you were eligible but didn’t contribute the max to the 457b plan. You only get one shot at this and it cannot be opened and used in the final year of your employment. So, if you have already put in your papers to retire in 2017, this is no longer an option for you.
There are two complications to using your workplace retirement plan like this:
- You might learn about the bonus without enough time to contact HR / Payroll to make the necessary changes. Let’s say you have 12 more paychecks for the year and you just got paid $14,000 gross ($10k net to you). For the remainder of the year, you can contribute $1,170 extra per pay check to the retirement account and live off the $10k extra in your checking account until you change the contributions back to the normal amount for 2018. This is generally referred to as pocket-shifting and its only requirement is discipline not to spend on unbudgeted items.
- You may be among the 8% of Americans who are maxing out contributions throughout the year and have no ‘room’ for adding during the middle of the year because it will affect take home pay come autumn. This is a wonderful problem to have because it signifies great efforts to build adequate retirement savings. But, nonetheless, it’s a problem for those who want to save more. Consult your advisor on the use of Individual Retirement Accounts (IRAs) … both Roth and Traditional … to see if you are eligible for use of these vehicles. Otherwise, depending on your expected tax situation in the coming months/years, there are certain investment vehicles which would make more sense than others.
So, the next time something like this comes up, will you listen to the little voice inside of you yearning to go to Belize, hit the lake in a sleek new speedboat, or upgrade your vehicle? Or, will you execute according to a well thought out plan?
Everyone’s situation is different and, I suspect, many people will choose a hybrid version of the above whereby some money comes home to be spent and another (hopefully significant) portion is deferred to the workplace retirement plan. Understanding tax burdens and retirement savings requirements not only involves several complex calculations but, it also needs the involvement of a trusted advisor who can provide quantitative answers as well as reinforce the appropriate behaviors for your situation.
As I mentioned earlier, it remains captivating to take part in another person’s decision-making process. This is your money and nobody should tell you how to make use of it. Making informed decisions tempered with personal needs and desires is only possible when one has the Full Picture …