Today I present to you a guest post by Nate Matherson. Nate is a Co-founder of LendEDU, a personal finance site dedicated to helping everyone learn about personal finance.
For many employees, an annual bonus is a big chunk of change that provides a nice boost to take-home income. When you get this lump sum of cash, it also presents a unique opportunity to make progress on your financial goals since you’re receiving a lot of money all at one time. At my job, bonuses are distributed in October based on the prior 12-months of company and individual performance. Personally, my annual bonus is an important part of my annual financial plan, and to a degree, helps me regroup after spending a little more than I should over the summer.
When used wisely, your annual bonus can help you to take big steps to improve your financial situation over the long-term. Unfortunately, many employees simply deposit this cash into their regular checking account and end up spending it on everyday items that don’t have a long-term positive impact.
The good news is, you don’t have to be one of them. Instead, consider taking one of these smart financial steps when you get your bonus from your boss.
1. Start or increase your emergency fund
Financial experts all recommend that you have an emergency fund with three to six months of living expenses. An emergency fund can save you from true financial disasters, such as foreclosure or repossession if you lose your job and income. It can also help you to avoid ending up in debt when unexpected expenses arise – as they inevitably will.
Most people don’t have an emergency fund of the recommended size. If you don’t have money saved for a rainy day, or if your emergency fund is too small, starting a fund or bulking yours up is an ideal thing to do with your bonus.
In fact, even if you have debt, it may be smarter to put the bonus cash into your emergency fund rather than allocating it towards debt payoff. Otherwise, you may make progress on your debt only to find yourself forced to borrow again as soon as you hit a bump in the road. This can be discouraging and can make it hard to break the cycle that keeps sending you further into debt.
2. Pay off debt
Repaying debt is another smart thing to do with your bonus, especially if you already have at least some money saved for emergencies.
Debt is damaging to your finances because it means some of every future paycheck is already promised to creditors and can’t be used to fulfill other financial goals or to help make your budget work. Debt also makes all your purchases cost more as you pay interest on everything you’ve paid for with a loan.
Making a big payment to outstanding debt can help you to become debt-free much more quickly. Whether you owe on credit cards, student loans, or a car loan, if you put your bonus towards your debt, you can drop the principal balance by a big amount. This will both cut time off the debt repayment process and reduce the total interest you pay since interest will be calculated on a lower outstanding amount due. And as a bonus tip, when interest rates are going down you may want to consider refinancing your debt to save even more on interest. Personally, I refinanced my student loan debt twice and was able to lower my rate from above 9% to below 4%. When you combine large prepayments with refinancing, the end result will be a much quicker debt payoff!
3. Make a smart investment
Investing is another great way to make sure your annual bonus improves your long-term financial situation. You could use your bonus to invest in a 401(k) if you have one available at work – especially if you aren’t maxing out the amount needed to score a match from your employer. You could also put your bonus into an IRA.
Both a 401(k) and an IRA allow you to claim tax breaks for retirement savings so your money stretches further. If you got a $2,000 bonus and made a $2,000 tax-deductible contribution to an IRA, this would save you as much as $440 off what you owe the IRS if you are in the 22% tax bracket.
And, if you invest $2,000 every year when you get an annual bonus and earn 7% returns over 30 years, your nest egg would grow to around $189,000 – which is a decent chunk of change that can help you to enjoy your retirement years.
4. Save for a big purchase
If you don’t have a lot of debt, already have a maxed out emergency fund, and are investing enough for retirement, you can also use your bonus to help you afford something big you may need in the future.
You may decide to save your bonus in case you need home repairs, for example, or to help you fund your upcoming wedding if you’ve recently gotten engaged. Often, weddings, home upgrades, and other big purchases necessitate borrowing – but they don’t have to if you have a dedicated savings account earmarked to cover these expenses.
Another great thing to do is to save your bonus to buy a vehicle. Many people spend virtually their entire life paying a car loan once per month. If you could save your bonus to help you pay cash for your next car, you could eliminate this monthly bill and have more money to do other things.
Saving for a down payment for a home is also a good option. If you don’t put down at least 20% when you buy a house, you’d need to pay an additional cost for private mortgage insurance to protect the lender. Avoiding this makes your home more affordable. A bigger down payment can also help you score a lower interest rate on a mortgage loan, which could save you for decades.
What’s the best thing to do with your bonus?
The best use of your bonus is going to depend on your specific financial situation. If you don’t already have the basics covered – such as saving for emergencies and for retirement – this is likely the best use of your cash. But, paying down debt or saving for purchases to avoid debt in the future can also be wise moves.
The key is to make a plan and do something with your bonus cash so it isn’t just spent. You worked hard to earn your bonus, and you deserve to use the money to help improve your long-term financial situation.
Let me know, what are you doing with your bonus?