How to Invest a Bonus (Or Other Lump Sum)
By: Cameron Diehl, CFP®
Friends – The end of the year is a time when some workers receive a large portion of their compensation – either through a bonus, contributions to employer retirement plans or a distribution from their business.
Receiving a lump sum can be daunting from a financial planning perspective and deciding how to deploy that money is a conversation I have frequently this time of year. With these conversations in mind, I wanted to share a typical framework I use to help guide these decisions with my clients.
Of course this is a highly personal and nuanced process, so please reach out if you have any questions about how it may apply to your own planning.
- Plan For Taxes – A lot of people have sticker shock when they actually see their bonus deposited into their accounts. The difference between the number you’re told and what you receive after taxes are withheld can be substantial. This may be higher than what you end up owing and you may receive some back as a refund when you file your taxes, but it’s important to anticipate this withholding.
- Pay Down Debt – Paying down debt is always a top priority in my conversations with clients. If you have outstanding credit card bills or other high-interest debt, that can be a great place to start.
- Complete Your Emergency Fund – Rules of thumb recommend having anywhere from 3-6+ months’ of living expenses set aside in cash for an emergency. If you’ve not reached whatever goal you’ve set for yourself in this regard, a bonus can help you catch up.
- Allocate For Upcoming Cash Flow Needs – Additionally, If you have any larger expenses or investment commitments planned for the upcoming year or so, I always recommend adding up those amounts and setting aside additional cash from bonuses to cover them.
- Save For Retirement – Are you on track with your retirement savings? Bonuses can quickly shore up contributions to either reach maximums for the year or targets you’ve set to keep yourself on track across your 401(k)s, 403(b)s, IRAs, HSAs, etc. At a minimum, ensuring you receive the full match available to you from your employer should be a no brainer (even ahead of the items higher on this list). Pre-tax contributions have the added benefit of reducing the tax hit to your bonus.
- Make Gifts – If you do regularly planned giving, either to favored causes or into trusts, gifting from bonuses around year-end is a great time to do so. Don’t forget to consider gifting highly appreciated securities in the process, which can offer significant tax advantages.
- Invest Over Time – With any remaining amounts, I often recommend breaking that amount into equal installments and investing regularly over the next 12 months into whatever accounts you prioritize – whether a taxable investment account or 529, for example. This helps to smooth your investment timing from one bonus to the next and avoid arbitrarily investing a large lump sum at a single point.
- Rebalance Your Portfolio – Bonuses also provide an opportunity to rebalance your portfolio with new money to minimize tax consequences of doing so – whether this is getting back to your targeted mix of stocks and bonds or managing a concentration that has developed in your employer’s stock (especially if a portion of your bonus is received in your employer’s stock).
- Other Opportunities – As you progress through this list, there are a number of other options to consider such as permanent life / long-term care insurance, deferred compensation plans, profit sharing plans, etc.. These are complex strategies that should be considered carefully with informed advice.
Disclosure: Any opinions are those of Cameron Diehl and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. Matching contributions from your employer may be subject to a vesting schedule. Please consult with your financial advisor for more information. Every investor's situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
