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Financial Planning > Tax Planning

How to Invest a Year-End Bonus

By Roger Wohlner

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What You Need to Know

  • Year-end bonuses provide an opportunity for clients to invest, pay down debt or use the money in other ways to enhance their financial situation.
  • Be sure that your client understands how the bonus will be taxed and that they have all taxes stemming from the bonus covered.
  • Encourage your client to use some of the money to enjoy themselves if possible.

Your client will be receiving a year-end bonus and would like your advice as to how to best put this extra money to work. In providing this guidance, there are a few things to consider.

When and How Will the Bonus be Paid?

Will they receive the extra money this year in 2022, or in early 2023? This affects their taxes and other issues such as retirement plan contributions.

Year-end bonuses are generally paid as cash to employees. However, they can also be paid in the form of stock, including stock options, restricted stock units (RSUs) or other forms. They can also be paid as a contribution to the employee’s profit-sharing account. Be sure to get a handle on the timing of the payment and the form in which the bonus will be paid.

Taxation of Bonuses

Bonuses paid as cash are taxed in one of two ways.

The IRS lumps bonuses with items like severance pay and commissions into the category of supplemental wages. The withholding rate on supplemental wages can either be done using the percentage method or the aggregate method.

With the percentage method, your client’s employer can withhold a flat 22% of the bonus amount regardless of your client’s tax bracket or their normal withholding on their salary. If the amount of bonuses paid within a calendar year exceeds $1 million, the tax withholding amount must be at 37% regardless of your client’s normal withholding amount.

The aggregate method can be used by employers if they lump your client’s regular salary together with their bonus in a single paycheck. Under this method the taxes withheld would be based on your client’s normal withholding elections.

Bonuses in the form of stock options or RSUs are generally not taxed in the year they are granted. There are future tax planning implications for your client based on the type of stock compensation and other factors.

What to Do With a Bonus

The best uses of your client’s bonus will vary by each client’s situation. Here are some ideas to consider. Depending upon the amount of your client’s bonus, they may be able to put it toward several of these uses.

Ensure Taxes Are Covered

Whether through extra withholding or setting aside some of the bonus money as needed, make sure that your client’s tax liability for 2022 or 2023 will be covered in light of the extra amount received via the bonus.

Be sure to take a look at your client’s tax situation to ensure that they will not have an issue at tax filing time, whether due to the amount of the bonus or under-withholding during the year. They may want to obtain an estimate of the tax liability for the year from their tax professional. If it looks like they will owe a sizable amount, then directing some of the bonus money toward paying their taxes makes sense.

Maximize 401(k) Contributions

If your client will be receiving their bonus payment this year, review their 401(k) contributions to ensure that they are on track to contribute the maximum amount of $20,500, or $27,000 if they are 50 or older in 2022. They may need to increase the deferral percentage for that payment to hit the maximum, or they may be able to ask their employer to defer a set amount from the bonus check.

If the bonus will be paid in 2023, use the bonus amount along with their normal compensation to ensure they contribute the maximum amount of $22,500 or $30,000 for those who are 50 or older for 2023.

Set up a Mega Backdoor Roth

If your client’s employer offers this option, this is a way for your client to contribute extra after-tax dollars to the 401(k) plan. For 2022, the limit is $40,500; for 2023 the limit is $43,500. These limits are in excess of annual 401(k) employee contribution limits. A mega backdoor Roth offers a vehicle for clients who can’t contribute directly to a Roth IRA due to their income, or who want to accumulate larger amounts in a Roth account over time.

They may still be able to contribute for 2022, or at the very least they can set money aside from their bonus to offset money contributed from their paycheck for 2023.

Contribute to an IRA

Contributing to an IRA is a good use of some of the client’s bonus money, especially if your client has contributed the maximum to their 401(k) or is not covered by a workplace plan. Depending upon your client’s income, they may be able to contribute to a traditional IRA on a pretax basis or to a Roth IRA. If their income is too high for these options, they can also contribute to a traditional IRA on an after-tax basis.

Another option they might consider is a backdoor Roth. Under this scenario, your client would make an after-tax contribution to a traditional IRA and then convert this amount to a Roth IRA. The conversion will be taxed based on the amount of assets your client has in traditional IRA accounts that consist of pre-tax contributions and earnings.

If your client is married, be sure to suggest IRA contributions for both of them if applicable.

For 2022, IRA contributions can be made up to the tax filing deadline with no extensions. Contributions for the 2023 tax year can be made starting in January.

Consider Taxable Investments

Investments within taxable brokerage accounts are another option for some of this extra money. Investments can be made in line with the client’s asset allocation. This is a good option in cases where your client has maxed out contributions to retirement accounts and want to diversify the tax status of their investments.

Rebalance the Portfolio

When investing any bonus money across retirement and taxable accounts, this money should be invested with an eye toward rebalancing the client’s portfolio as needed. With the market volatility we’ve seen in 2022, many clients may find their portfolios a bit over- or under-allocated in various asset classes.

As part of their rebalancing efforts, new money invested from the bonus can be used to shore up the asset classes where the client may be under-allocated. Adding new money versus selling some existing holdings to rebalance can help your client avoid capital gains taxes on sales within their taxable accounts.

Put Money Into College Savings

For clients who are saving for college expenses for their children, some of this money can be directed to a 529 plan or other investments earmarked for their children’s education. Investing in their children’s future is a priority for many financial advisors’ clients.

Make Charitable Contributions

For clients who are charitably inclined, using some of the bonus money for charitable contributions is a way to do good for others and to get a tax break in the process. If they are able to itemize their deductions, the charitable contribution will represent a win-win situation for the charity and for your client.

Besides a cash contribution directly to a charity, they might consider funding a donor-advised fund (DAF). This is an investment account that allows them to make contributions to qualified charitable organizations over a number of years. The contributions to the DAF are deductible in the year they are made.

Pay Down Debt

If your client has debt they are paying off gradually, especially high-interest debt, using some or all of their year-end bonus to pay down this debt can make financial sense. The money that your client has been using toward debt payments can be directed toward other areas such as saving for retirement, funding college for their children or any other use that is a priority for your client.

Paying this debt down can offer a good return on the bonus money used toward this payment, especially if their debt carries a high interest rate — credit card debt, for example.

Contribute to an Emergency Fund

Experts suggest an emergency fund consisting of six months of ongoing expenses. If your client doesn’t have an emergency fund, or if the amount is insufficient to cover their needs for six months, this would be an ideal use of some of their bonus money.

Encourage Your Client to Have Fun

Your client worked hard for the bonus they will be receiving. Encourage them to take some of the money and spend it on something they enjoy. Maybe this is a vacation, perhaps dining in some upscale restaurants or buying tickets to some live entertainment events. Their long-term financial plan should leave some room for them to enjoy the present.

Summary

A year-end bonus is a nice incentive that many companies provide to employees. In some cases this bonus can be a significant percentage of your client’s total compensation. This is often the case for senior management and those involved in sales.

The ideas discussed above represent some solid uses for your client’s bonus, but there are certainly other ways to deploy this money. Directing clients as to the best use of this money will vary with their financial situation and the amount of the bonus. This is a good time to do a financial planning review with your client, especially if the bonus amount is significant, and to work with them to decide the best way to use this money to improve their financial situation.

Roger Wohlner

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