The Best Ways To Spend Your End of the Year Bonus

This article originated from a reader question…

For example, suppose I get, say, a $5000 bonus before the end of the year, would I be better off giving it away or putting it in 401k to avoid tax consequences, putting some in Roth IRA (if I still qualify), paying the tax bill on a conversion of some rollover IRA $$ to a Roth, paying my child’s tuition bill (too late for 529 now) to avoid debt, or replacing the 10-year old heating and A/C system to lower ongoing utility costs?

The specifics of this question are unique to the individual who asked the question, but the reasoning behind the response can be tailored to fit many other circumstances.  What follows is an example of the process that I typically go through to assist folks in the process of understanding the impacts of various choices…

Assumptions

To start off, we need to make some assumptions about the situation that will guide us through the process.  The reader who posted the question leaves us with a few clues that help us understand his tax situation – he’s made reference to income level with the “if I still qualify” parenthetical comment, so we should assume that the tax bracket for the bonus money is relatively high, close to the limit for Roth IRA contributions, which for 2010 is the 28% bracket.  In addition to the marginal tax rate, we’ll assume that the asker is married, filing taxes jointly.  We’ll also assume that the asker’s spouse is already contributing to a retirement plan (so a Spousal IRA contribution is not in play).  So in all cases the net after-tax bonus is assumed to be $3,600 (28% or $1,400 is withheld).

We also assume that in retirement, the tax bracket will be lower than it is currently, making tax deferral today more beneficial – meaning that we want to pay as little tax as we can today if we can pay tax on that income tomorrow.

Other assumptions include:  the asker of the question has not maximized his contributions for the year to a 401(k), or a Roth IRA; the child (student) has not exhausted his student loan options, and funds can be borrowed at an unsubsidized rate of 6.8%; plus, the cost of purchasing a new heating and A/C system for the home in question is $7,000; and lastly, there are funds available to pay for the needed heating and A/C unit or the tuition bill (if a loan is not used).

Analysis

Donating – This would give you a tax deduction, so it would reduce your overall tax by $1,008.

Contribute to 401(k) – In this case, given the relatively high tax bracket, there would be a tax reduction (from all other options) of $1,400, allowing you to put the entire $5,000 to work in the retirement account.  The assumption here includes the fact that you expect your tax bracket to be lower in retirement than it is presently – since when you take the money out of the 401(k), it’ll be taxed as ordinary income, thereby reducing the benefit of this tax reduction today.

Roth IRA contribution – If the asker of the question has not made his Roth IRA maximum contribution for the year and all other tax reduction and deferral options have been exhausted, this might make a great deal of sense.  However, since there are other alternatives to look at, the Roth IRA contribution might not be the best option to use in these circumstances – since the tax cost of the money is relatively high.

Paying the tax on a Roth IRA conversion – Again, given the tax bracket involved here, a Roth IRA conversion is probably not a good idea.  This amount of $3,600 could pay the tax for up to $12,850 of Roth Conversion, but as we have discussed in other articles, at the 28% bracket this is a somewhat costly conversion.  It is assumed that in retirement your tax bracket would be less than the 28% current bracket – so only a very long period of deferral in the Roth account would prove beneficial.

Paying your child’s tuition – Paying the tuition bill could be a good use of these funds, because you would likely be eligible to use the American Opportunity Tax Credit on the tuition payment, giving you a credit of up to $2,500 directly against your overall tax, although the amount attributable to the net $3,600 would be $2,400 at most.  This would eliminate the tax on the bonus altogether and give you an additional $1,000 in tax credit.

Replacing the aging heating and A/C – A 30% tax credit is available on the purchase price of eligible Qualified Residential Energy Property, up to $1,500.  The cost of the installation is not allowable for the credit, this would be added to the basis of the property.  For the net $3,600 from the bonus, the credit would be $1,080.  In addition, assuming that the current system in place is far less efficient than a new system, this might equate to as much as an annual reduction of $200 or so in your annual heating and cooling costs.

Putting it all together…

Now that we’ve looked at the tax benefits of the options available, let’s compare them all side-by-side:

Donation – $1,008 tax reduction

401(k) – $1,400 tax deferred

Roth Contribution or Conversion – no current tax benefit

Tuition – $2,400 tax credit

Heating & A/C – $1,080 tax credit, plus ongoing $200 reduction in heating/cooling costs

So – the best route to go with this bonus, purely from a tax benefit standpoint, is paying the tuition bill.  This would give you all of the withheld tax back, plus an additional $1,000 in tax credits.  However, if you already have other funds set aside to use to pay the tuition, you might use those instead, and then use the bonus for one of the other options.  (It should also be noted here that, if you haven’t taken advantage of your employer matching contributions in your 401(k), that would be the best possible place to use the bonus money.)

In the case of the heating and A/C system – this is a matter of priority… if the system truly needs replacing (beginning to show signs of failing), then you might put it higher in the priority order above the tuition or the 401(k) plan.  For example, the student or the parent could get unsubsidized loans to pay for the tuition bill, since the interest on these loans can be deducted from taxes in the future, and then use the bonus (and the tax credit) to pay for the heating and A/C system.

Other options that you might consider for these funds would be: pay down high interest debt (credit cards, auto loans, or student loans), spend it on your own education (a master’s degree could make a significant difference in your future income), improve your “emergency” fund, or consider starting your own small side business.  You could also use a portion of your funds to treat yourself and your family to a vacation, or perhaps some other leisure pursuit that will improve your life or provide other intangible benefits.

Of course, all of these options require you to put your own priority system to work.  We’ve covered the tax implications – now it’s up to you to decide what makes the most sense for you.  If it is of a high priority for you to make donations to a charity of importance to you, this might be the best option for you.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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