Given HR's role in managing employee benefits and compensation, I receive a lot of questions around this time of year regarding annual bonuses. With most organizations paying out short term incentives for 2018 within the next couple of months, it's wise to get your ducks in a row before your bonus hits.
To help, I caught up with Dustin Sventy, Executive Vice President and Chief Investment Officer at the Hantz Group. Hantz is a 21-year-old financial services company that was founded by serial entrepreneur, John Hantz. With a family office vibe and a holistic approach to finances, I found Sventy's advice practical and easy to understand.
Here were his responses to the three most common questions during bonus season. As a quick caveat, Sventy is not a CPA. Please consult a tax professional before making final decisions.
Here's some ideas to consider.
1. How Bonuses Are Treated
Annual bonuses are taxed as ordinary income which means they are subject to your normal tax bracket--they can bump you into a higher tax bracket as well. Also, because bonuses are distributed through your paycheck, your deductions for 401k, Medicare, and Employee Stock Purchase Plans, for example, still come out.
With most per pay-period contributions being percentage based, you should expect larger than normal lump sums to be taken from your check.
In planning for the impact of tax and deductions, make sure to update your amount of dependents, and adjust your contribution percentages to either curtail taxable income for that pay period or reduce the total amount of deductions (if you need the cash).
2. How to Minimize Taxes
In addition to adjusting dependents, the following options offer extra tax savings:
- Health Savings Account (HSA): An HSA is a tax-deductible savings plan that allows you to save pre-tax dollars to put towards future medical expenses. With medical bills being one of the largest "red-line" items for most, HSAs are a great use of your tax savings.
- 401(k) or Traditional IRA: A 401(k) and a traditional IRA are tax-advantaged retirement accounts that are exempt from federal income tax during the year in which you make contributions. For example, if you made $60,000 and contributed $10,000 to a 401(k), your taxable income would be $50,000, not $60,000. Using 2019 tax brackets, that would save you $2,200.00 in tax. For 2019, the maximum amount you can contribute to a 401(k) account is $19,000 with a $6,000 catch-up policy for those who are 50 years old or older, and $6,000 for a traditional IRA with a $1,000 catch-up.
- Deferred Compensation Plan (DCP): DCPs allow you to defer payment and avoid paying tax until you need the money, or when it's more opportunistic to take it. However, DCPs aren't for everyone. Before you enroll, it's important to remember how such plans work. When you defer compensation, you become a creditor of the company. That means you're in line with all the other debt creditors it may have. There is a risk of complete loss of assets with a DCP.
3. What to Do With the Extra Cash
If you've already received your bonus and have extra cash sitting in the bank, there are a few different avenues you should consider.
- Pay down high-interest debt: Examples could include credit cards, car, or payday loans. Tackling these first is wise for a couple of reasons. One, the faster you pay them down, the less interest you'll pay, and two, the less debt you carry, the more likely you are to stick to your investment strategy. In other words, you won't decrease contribution percentages to 401(k), pull money out of IRAs, or tap into your kid's college fund.
- Invest and let it grow: Because contributions to Roth IRAs are post-tax, they are a great investment vehicle for taxed dollars. For 2019, the maximum amount of money that you can contribute to a Roth IRA is $6,000 with an additional $1,000 catch-up policy for those who are 50 years old or older.
Congratulations on your bonus--you earned it. However, not taking the time to plan according to your financial goals could result in missed opportunities to maximize its impact.