(Bloomberg Opinion) -- Making the most of a bonus is always important, but 2022’s payout feels even more precious. Many workers, especially in finance and technology, are likely to see slimmed-down bonuses. Amid economic uncertainty, maximizing those dollars is crucial.
But should you sock away as much as you can in a tax-deferred retirement account to minimize the tax liability? Or keep the money somewhere accessible and liquid so you have cash on hand for any emergencies? Or use it to pay off debt?
There may be situations where it’s better to use a bonus in the here and now, like paying off high-interest credit-card debt. But if you have a relatively low interest rate on your debt — like a fixed-rate mortgage — using a bonus to pay it down doesn’t necessarily make a whole lot of sense.
For most people, prioritizing retirement contributions is the better course of action. And one benefit of maxing out a 401(k) early in 2023 is that it’ll enable investors to get in while the market is still down and stocks are cheap, says Mike Wren, a certified financial planner at Legacy Financial Strategies.
There are also tax advantages. Your bonus is generally taxed at the same rate as the rest of your income. Employers often withhold a flat rate of 22% if the bonus is under $1 million (if it’s more than $1 million, then it’s 37%). For workers subject to income tax rates above 22% (meaning they make more than $95,375, or $190,750 if married and filing jointly) then too little will be withheld and they’ll owe more come tax time.
Unless, that is, you put the bonus money in a tax-deferred retirement account. Then that bonus isn’t considered part of taxable income when calculating income taxes. (You’ll still owe Social Security and Medicare taxes on any bonus money that goes into a 401(k), according to Eric Bronnenkant, head of tax at online financial advisory firm Betterment.)
Thanks to inflation, contribution limits have risen. For 2023, those under 50 can put up to $22,500 in a 401(k) (a $2,000 increase from last year) and workers who are 50 and over can put in $30,000.
If you decide to divert some of your bonus to your 401(k), be aware that you may need to change the default setting for how much you typically contribute from your regular paycheck.
Also, if your employer offers a company match, make sure you understand how it works. Some may do what’s called a “true up” at the end of the year where they’ll match your 401(k) dollars regardless of when you contributed. Others use a system where they only contribute when you do, so you might be penalized for front-loading contributions.
Finally, a note of caution for those who figure they’ll just put a bonus in a 401(k) and then borrow from their retirement account if they need funds later in the year. For some, that can make sense, but not for anyone thinking about changing jobs or being laid off.
If you leave your job, you’ll typically have to repay the loan no later than when your taxes for that year are due. If you’re unable to do so, the unpaid balance will be treated as a distribution and you’ll be on the hook for income taxes as well as face a 10% early withdrawal penalty if you’re younger than 59 and 1/2.
In that case, the desire to maximize a bonus by cutting taxes could seriously backfire. For most everyone else though, a 401(k) is still one of the best ways to put a precious payout to work.
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To contact the author of this story:
Alexis Leondis at [email protected]