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Use Your Bonus Wisely to Catch a Tax Break

By weighing the tax implications and your long-term goals, you can make your bonus go further.

By Betterment  
on

100 dollar bills in stacks bonus money benjaminsHere’s how you can reduce the impact of taxes and get the max out of your bonus.

Bonuses are tricky. Part windfall, part tax event, part savings opportunity—you need to juggle multiple aims and concerns to maximize your yearly (or quarterly) perk.

Tax time is coming, so keep reading as it’s still possible to contribute to a traditional or Roth IRA for 2015—yes, even if you also participate in your company’s 401(k). Betterment’s efficient IRA set-up can help you get there quickly and securely, so you get the added tax break.

How does a bonus get taxed?
Bonuses are considered “supplemental income” by the IRS, which means they could be withheld on differently than your regular salary. Bear in mind that Betterment is not a tax advisor, nor should this article be considered tax advice. Please consult your tax professional if you need tax advice.

The IRS suggests a flat withholding of 25% from bonuses, and many employers follow that method. (Remember that withholdings are meant to be an estimate of how much you’ll owe at the end of the year, not the actual tax itself.) But some employers use the aggregate method, in which your whole bonus is added to your regular paycheck, and the combined amount is withheld at the normal income rate, as though that amount is representative of what you make every paycheck, which could be higher (or lower) than 25%.

Some people believe that bonuses are taxed at a higher rate than ordinary wages, but that’s not the case. The aggregate method of withholding can result in bumping you into a higher estimated tax bracket, which creates the illusion that you “keep less of it,” but no special tax rates apply just because a payment from your employer is characterized as a bonus. So a bonus is like a raise, but when your income goes up, it could do more that just move you to a higher tax bracket—you could potentially lose certain deductions and tax credits.

Now, here’s how you can use tax-deferred or even taxable accounts to preserve and grow your windfall

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1. Beef up your 401(k)
Before you add your bonus to your 401(k), check with your employer about how bonuses are handled. In some cases, your company may not allow you to make 401(k) contributions using your bonus.

In others, your 401(k) plan may be set up to withhold the same percentage from your bonus as from your paycheck. Thus, if you typically contribute 10% from every paycheck to your 401(k), that same amount could be withheld from your bonus (unless you say otherwise). So in the case of a $15,000 bonus, $1,500 would go into your 401(k) for 2015, which may be too little for your aims.

Of course, you can’t contribute more than the annual limit, so be sure to check how much you’ve contributed for the year to date. The contribution limit for your 401(k) for 2015 is $18,000 ($24,000 if you’re over 50).

And don’t assume that a lump-sum deposit is best, especially if your employer matches your 401(k) contributions. A single large deposit might not get the same amount of matching dollars that a comparable amount would if you spread the deposits over time. Betterment’s resident CFP® Alex Benke notes that it depends on your employer’s matching structure.

2. Take advantage of multiple accounts
Then, here’s the part you may not be aware of: Depending on your income and whether you or your spouse is participating in a company retirement plan, you might be able to reduce your taxable income further by contributing to your flexible spending account (the maximum is $2,550, $5,000 for dependent care for 2015), a health savings account (the maximum for a family is $6,650 for 2015), and a traditional or Roth IRA.

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Many people don’t realize that you can participate in a company plan and still fund a traditional or Roth IRA. So you could contribute to your 401(k) for 2015 and contribute to a traditional or Roth IRA for 2014 (up until April 15, 2015), or contribute to a traditional or IRA for 2015—or a combination of those.

As the IRS notes:

You can contribute to a traditional or Roth IRA whether or not you participate in another retirement plan through your employer or business. However, you might not be able to deduct all of your traditional IRA contributions if you or your spouse participates in another retirement plan at work. Roth IRA contributions might be limited if your income exceeds a certain level.

3. Invest in a ‘Happiness Annuity’
If it’s not possible or advantageous to put your money only into tax-deferred accounts, use your windfall to invest create “a gift that keeps on giving.” You could spend it all, sure, but by investing your windfall in a well-diversified portfolio, you can create an additional source of cash flow that steadily adds to your quality of life, year after year: i.e. a happiness annuity.

Studies show that steady cash flow increases often feel better than a lump sum that’s here today, spent on the Canary Islands tomorrow.

Betterment is the largest, fastest-growing automated investing service, helping people to better manage, protect, and grow their wealth through smarter technology. With more than 50,000 customers and $1 billion in assets under management, the service offers a globally diversified portfolio of ETFs, designed to help provide you with the best possible expected returns for retirement planning, building wealth, and other savings goals. Betterment is a CNBC Disruptor 50 and Webby award winner and has been featured in the New York Times, Forbes, and the Wall Street Journal. Betterment helps people to achieve a smarter financial future with minimal effort and at a fraction of the cost of traditional financial services. Learn more here.

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