The Best Way To Use Your Bonus (Hint – Minimize Taxes)

One of the great perks of being a corporate stooge is that many of us are eligible for some type of annual bonus.  Most folks take their bonus money and run, choosing to treat themselves with it, sometimes burning up the money before the check actually clears.  Personally, I prefer to put that money to work and to use it to push myself closer to my early retirement goal.

Most of us know blowing the money on a new purse is not the best use of it.  What can we do to make smart use of that additional income?

How Is A Bonus Taxed?

First, we need a basic understanding of how a bonus gets taxed in order to fully utilize it. A bonus is considered supplemental income, which is compensation received on top of ordinary earnings.  Your regular paycheck is considered ordinary income.

Ordinary income is taxed based on the tax bracket you fall in, and based on the W-4 exemptions you’ve claimed.  Supplemental income is taxed at a flat rate of 25%, unless you are lucky enough to earn $1 million or more in bonuses, then it’s taxed at 39.6%.

Supplemental income can also be taxed using another method — the aggregate method.  That’s relatively uncommon however, so I won’t dive into it here.

In addition to the 25% flat federal tax, the bonus is also subject to social security tax (6.2%), and medicare tax (1.45%), which totals 32.65%!  Finally, depending on where you live, state taxes may also be tacked on.

State Withholding Requirements

Arkansas: 5% of your taxable distribution
Delaware: 5% of your taxable distribution
Iowa: Less than $6,000 = 0% of your taxable distribution
More than $6,000 = 5% of your taxable distribution
Kansas: 4.5% of your taxable distribution
Maine: 5% of your taxable distribution
Maryland: 7.75% of your taxable distribution
Mississippi: 5% of your taxable distribution
Nebraska: 5% of your taxable distribution
North Carolina: 4% of your taxable distribution
Oklahoma: 5% of your taxable distribution
Vermont: 24% of Federal Withholding Amount
Virginia: 4% of your taxable distribution
Washington DC: 8.95% of your taxable distribution
California: 10% of Federal Withholding Amount
(Payee can elect to opt out of state withholding)
Michigan: 4.25% of your taxable distribution
(Payee can elect to opt out of state withholding)
Oregon: 8% of your taxable distribution
(Payee can elect to opt out of state withholding)

 

In my case, I live in Kansas (4.5%), so my total tax is a whopping 37.15%.  This means if I take a $5,000 bonus as straight cash, I walk away with $3,140.  Certainly better than nothing, but I think this can definitely be optimized, so let’s explore some options.

Option 1 – Take The Cash, Spend The Cash

I don’t poo-poo this option outright.  There are legitimate reasons to take the cash and spend it.  You could use the cash to pay off high interest loans / credit cards, or help build up an emergency fund if you have no reserves.  Those are justifiable reasons to take the cash and ‘spend’ it.

Notice when I say spend, I mean paying down debt, saving for a rainy day, or paying for Timmy’s braces.  I don’t mean buying that new golf cart you had your eye on because you play 9 holes four times a year.

Option 2 – Take The Cash, Invest The Cash

Instead of paying down debt with the cash, you can stick it into an IRA (up to $5,500).  Though you’ll still be taxed the full amount initially.  If you invest in a traditional IRA, then that could help reduce your tax burden when you file your end of year returns, depending on your income. If you choose a Roth, then you don’t get that deduction, but that money can grow tax free, and once you hit 59.5 yrs of age you can pull the earnings out without paying additional taxes.

Other options include investing in a 529 college savings plan, which would also be deductible on your tax returns, and it will help little Timmy afford college.  A Health Savings Account (HSA) is also a great choice if you have access to one.  Medical expenses are inevitable for all of us.

If you’re looking to spice up your life a little, then that cash could be used to invest in yourself via a side hustle, or furthering your education.  These may be deductible under the right circumstances and can, ideally, generate future income.

Option 3 – Go Directly To You 401k

This option isn’t open to everyone.  It’s likely only available to people employed by larger organizations. That said, if you are in a healthy financial spot and don’t need the bonus money, you can save a ton on taxes if you stick it in your 401k and let it ride.  What you’re doing here is deferring your taxes until a later date, not avoiding them.  However, if you defer until you have significantly lower income (i.e. retirement) then you can save a bundle on the taxes.

Of course, there are some limitations to this, and the flexibility of this plan depends on your employer.

My employer will automatically put my bonus into a “Bonus Savings Account” (same account as my 401k).  They do this in the form of corporate stocks.  They also “gross up” my bonus by 18.45% to help offset taxes should I choose to remove the money from my 401k.  Now, if I choose to do nothing until retirement, here’s what happens with that money:

-> Deferral of income taxes (Potential to save a lot if you wait until your income is lower)

-> NO social security taxes if you’re below the social security wage base (saves 6.2%)

-> NO medicare taxes, ever (saves 1.45%)

-> I keep the entire additional “gross up” of 18.45%

-> Growth of that money based on growth of the company’s stock price

-> Automatic reinvestment of dividends from my company stock (1.6%)

Now, I don’t have to keep it in company stock if I don’t want to.  I can choose to move the money to any other available 401k fund (like a Vanguard index).  As long as it stays in the 401k account, I pay nothing in taxes.  Also, if I move out of my stock, I still get the dividend reinvestment no matter what fund I am in.

In a pinch, I can still withdrawal this money at any time; I just have to pay income tax on it.  I still avoid the medicare tax and social security tax though!  That’s 7.65%.

There are a couple things to keep in mind with option 3:

  • How much you gain depends on when you take the money out of your 401k. If you hold off until your income lowers and/or you retire, the differences can be huge.
  • Depending on how your organization is set up, this may or may not count towards the $18,000 individual contribution max. In my case, it DOES NOT count since the max is based on individual contributions, and the bonus is considered an employer contribution and it’s technically a “savings account”.

Which is the best?

As with all things finance related, determining the best option is highly personal and depends on individual situations.  That said, let’s do a general compare between these options over a 20 year period, assuming a modest 5% annual return.

Option 1 (Cash Out)

$5,000.00 Initial bonus
$1,250.00 25% flat tax
$225.00 4.5% Kansas tax
$310.00 6.2% social security
$72.50 1.45% medicare tax
-$1,857.50 Total lost to tax
$3,142.50 Total after 37.15% tax
$3,142.50 Total after 5% return over 20 years, compounded annually (duh, you didn’t invest it)

 

Option 2 (Cash Out – Invest in IRA, 529, etc.)

$5,000.00 Initial bonus
$1,250.00 25% flat tax
$225.00 4.5% Kansas tax
$310.00 6.2% social security
$72.50 1.45% medicare tax
-$1,857.50 Total lost to tax
$3,142.50 Total after 37.15% tax
$8,337.99 Total after 5% return over 20 years, compounded annually

 

Option 3a (Direct to 401k then cash out, no reinvest)

$5,000.00 Initial bonus
$1,000.00 20% witholding tax
$225.00 4.5% Kansas tax
$0.00 6.2% social security
$0.00 1.45% medicare tax
-$1,225.00 Total lost to tax
$922.50 +18.45% Gross Up
$4,697.50 Total after tax / gross up

 

Option 3b (Direct to 401k until retirement)

$5,000.00 Initial bonus
$0.00 25% flat tax / 20% witholding tax
$0.00 4.5% Kansas tax
$0.00 6.2% social security
$0.00 1.45% medicare tax
$922.50 +18.45% Gross Up
$5,922.50 Total after tax / gross up
$21,264.21 Total after 6.6% return over 20 years (5% Growth PLUS 1.6% dividend reinvestment), compounded annually
$2,126.42 -10% income tax upon withdrawal
$19,137.79 Total cash in pocket

 

Summary:

Options over 20 years, 5% annual interest, 1.6% dividend in 401k
Cash In Pocket
Option 1 (Cash Out) $3,142.50
Option 2 (Cash Out – Invest in IRA, 529) $8,337.99
Option 3a (Direct to 401k then cash out, no reinvest) $4,697.50
Option 3b (Direct to 401k until retirement) $19,137.79

 

The choices are obvious.  If your company allows you to go directly to your 401k, do it.  Even if you immediately cash out that money and don’t reinvest it, you’re a whopping $1,555 ahead with minimal effort.

If you can keep that money in your 401k until retirement and the contribution doesn’t count towards your $18,000 max, this strategy is an amazing way to super-charge your 401k.

If you can’t send it to a 401k, don’t just blow it.  Invest that money into a traditional IRA or 529 so you can capture the deduction on your tax returns, and your future-self with greatly appreciate the returns on that money.

My bonus philosophy is simple: Put that money to work.  Hopefully this post helps give people some perspective and gives them enough information to make better use of their bonus money.  Don’t just give it all to Uncle Sam!

-Andrew

 

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