You got a bonus. Nice. In my maturity, I have grown to appreciate an extra $10,000, $20,000, or $100,000 dropping into my lap.
So, first take a moment to appreciate this nice little (or not so little) windfall. Whoo!
Next, let’s tackle this question, which we’ve received from multiple clients just in the last two weeks (it’s Annual Bonus time): Should I contribute my bonus money to my 401(k)?
Generally, you want to max out your 401(k), and I care less about how or when you do it.
Let me position this question in the universe of “Things to Worry About”: Don’t.
Contribute from your bonus or not…it doesn’t matter as long as the money gets in there somehow.
Your total savings rate is waaaay more important than when or how you save to your 401(k), or even your choice to save to your 401(k) versus saving to another kind of account.
I say this because I don’t want you to stress about this decision. This is icing, not the cake. This is optimization, not foundation.
[Do note that there is no tax benefit to contributing from your bonus versus contributing from your regular paycheck. Just get that thought right outta your head.]
All that said, there are some considerations that might make the decision more appropriate for your particular situation.
Why You Should Contribute Your Bonus to your 401(k)
You Might Leave Your Job this Year
When you leave your job, you lose your ability to put money into your company’s 401(k). Putting money into your company’s 401(k) is, generally, a very good thing: it’s super easy and you get tax benefits. So, continuing that logical chain, losing access to a 401(k) is a bad thing.
Therefore, if you think you might leave your job this year, then you’ll likely want to max out your 401(k) before you do. And one good way to max it out early is to fund it with your bonus.
Now, if you end up leaving this job and taking another job with a different company that also offers a 401(k), then you will not lose your ability to contribute to a 401(k). But, you might not know this ahead of time and so can’t rely on having another company’s 401(k) at your disposal. Maybe it’s smart to max out your current 401(k), just in case.
This logic applies to both the “usual” $20,500 pre-tax (or Roth) contribution and the less common (but increasingly common among big tech companies) after-tax 401(k) contributions.
You’ll Sleep Better Knowing Your 401(k) is Maxed Out
This is a perfectly good reason, all by itself, to max out your 401(k) with your bonus money. To get extreme about it, the purpose of money is to make you happy. Being stressed out is not happy.
If you can reduce your stress by maxing your 401(k) in March with your bonus money and knowing you don’t have to worry about any remaining contributions you have to make? Go for it.
You Will Need Cash Later in the Year
This usually happens in the form of “I spend way more money in November and December than I do the rest of the year, because of the holidays.” So, it can be really nice to have extra take-home pay at the same time.
This is just trying to match up your financial logistics with your psychology and behavior around money. If you were a robot, it shouldn’t matter whether you had extra take-home pay late in the year and less take-home early in the year; you could just add to savings when you’re “over” and take from savings when you’re “light.” But you’re a human, and matching your current income to your current expenses makes things easier.
Why You Shouldn’t Contribute Your Bonus to your 401(k)
You Need Cash Right Now
Maybe you need cash because you mismanaged something. Maybe you need cash because you’re taking home too little money from your regular paychecks because all that money is going towards an after-tax 401(k) and your company’s ESPP.
Whatever the reason, if your financial situation could be eased meaningfully by getting a bunch of cash Right Now, then don’t defer your bonus to your 401(k). Take it all home with you (minus taxes, of course).
It’s Easier to Make Exciting Progress Towards a Goal with Your Bonus.
This one is purely behavioral. If we were all robots, it wouldn’t matter. Alas, we are these squishy, irrational humans who don’t always do the optimal thing.
Let’s say your bonus is $20,000 (after taxes).
You have a goal that will cost you $20,000.
You could save for that goal with $1000 out of each semi-monthly paycheck. You’ll be waiting 10 months to get there.
Or you could direct your entire bonus to the goal and be done now.
You get to buy that car now, or pay off your credit card debt now, or book that vacation now.
Doesn’t that sound way more gratifying?
Or hell, if you’re saving for a sabbatical or a down payment, getting $20k closer to that goal in one fell swoop can be veeeery motivating.
No matter the goal or its time frame, you’re more likely to save for it if you feel motivated and optimistic about achieving it.
Your Take-Home Pay Won’t Be Consistent Throughout the Year
Another behavioral reason! (Maybe I shoulda gotten a degree in psychology instead of economics. In this line of work, understanding human behavior is certainly way more helpful than understanding money multipliers or comparative advantages.)
Things are easiest when they don’t change. Hell, that’s why many of us stay in unpleasant situations at work or in our finances or personal lives…it’s easier to keep doing the same thing.
Thankfully, this “it’s easier to keep doing the same thing” approach can be harnessed for good!
If your take-home pay is always the same amount of dollars, then you can set up the same savings or debt payment to happen from each paycheck. All the numbers are the same, paycheck after paycheck. Predictable.
But! If you finish maxing out your 401(k) in, say, March (because you funded it with your bonus), then your take-home pay goes up starting in April. Any saving or debt-payment plans that made sense earlier in the year might need to be tweaked (i.e., increased).
It’s obviously not impossible. I mean it’s just the most basic of arithmetic: you have $1000 more take home per pay period, you can now save $1000 more. But after working with enough clients, I know that any effort to make adjustments like this is often “too much” effort.
‘Tis best if you can set up your savings or debt-payment plan once and then not have to muck with it!
Your Company Doesn’t Offer a Match True-Up
One feature of your company’s 401(k) that you should figure out is whether or not the company “trues up” its matching contribution. This article from Betterment walks through some examples to illustrate the impact of the true up. (The true-up feature should be described in the Summary Plan Description…which you can ask HR for.)
Why does the true up affect this decision of contributing to your 401(k) from your bonus?
Without a true-up, your company puts matching dollars into your 401(k) only in the pay periods when you put money into your 401(k).
So, if you max out your 401(k) before the end of the year, you will not put money into your 401(k) for possibly many pay periods, and therefore your company won’t make matching contributions for those pay periods.
Well, if you max out your 401(k) in March because you shovel your bonus into it, then you have pay periods from April through December in which you are not putting money into your 401(k), and therefore not getting a match. Boo.
But! If your 401(k) has a match true-up, then, after year’s end, the company will ensure that you get matched for all the dollars you put into the 401(k), no matter when you made the contribution.
- True up? Feel free to put your bonus into your 401(k)
- No true up? Don’t put your bonus into your 401(k)
Taxes on Bonuses
Now, you know you’re not getting away from a conversation about income without at least a glance at taxes. Most importantly:
You will likely owe extra taxes on your bonus. Your company won’t withhold enough.
Bonus income likely has too little taxes withheld at the federal level. It’s considered “supplemental” income and therefore is withheld at the “supplemental” rate, which is 22%. If you are making above $90k this year (single) or $180k (joint), your top tax rate is higher than 22%.
Let’s say it’s 35%. That means that you owe to the IRS roughly an additional 13% of that bonus money in taxes. If the bonus is $50,000, then you owe another $6500. Don’t spend that $6500. It’s not actually yours.
In my world of “I value simplicity over optimization,” that means just paying that $6500 to the IRS immediately, and then boom! I don’t have to worry about it anymore.
Unnecessary but Interesting Tangent! Deferring Bonus to your 401(k) Possibly Simplifies Taxes
If you don’t understand what comes next, do not worry about it. It is not necessary to do the right thing for your bonus and taxes. It’s…fringe. Maybe this section is just an indulgence for me.
There is an interesting tax twist with regards to the “should I put my bonus in my 401(k)?”
This is a fact: Any dollars from your bonus that you put into your pre-tax 401(k), you don’t owe any taxes on. So, that “under-withholding” that your company would otherwise do on bonus income? Not gonna happen because you don’t actually owe any tax.
What is the effect of eliminating the need to withhold taxes on your bonus income? Your taxes will be withheld only from your regular paychecks for the rest of the year. And if those withholdings are set correctly (on your W-4), then enough taxes should be automatically withheld on allll your income, and you shouldn’t have to pay estimated taxes.
Please note that none of this changes your total tax liability for the year.
You cannot save taxes by putting your bonus—instead of your regular salary—into your 401(k).
The IRS just cares what your total income is for the year, not what form it came in (salary, RSU, bonus, etc.).
Putting your bonus into your 401(k) could simply smooth out when your taxes are due and withheld, possibly avoiding the need to pay estimated taxes.
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Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. We encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Flow Financial Planning, LLC, and all rights are reserved. Read the full Disclaimer.