“The windfall of great riches can, if mismanaged, make things worse, not better, for the recipients,” said American author and professor Michael Mandelbaum.
But you don’t need a college degree to know that extra cash shouldn’t be spent frivolously — that part is easy. The hard part is actually figuring out what exactly qualifies as a good way to use a small windfall. Here are six simple — and most importantly, smart — things to do with your bonus or commission check.
1. Build an Emergency Fund
One in four Americans has no emergency savings. If you’re guilty as charged, then use your bonus check to set up your emergency fund stat. A good rule of thumb is that your emergency stash should cover six months of living expenses.
When calculating your monthly expenses, go beyond just your mortgage or rent payment and include important recurring payments such as groceries, utilities, and minimum debt payments. If the final number shocks you, take that as a wake-up call about how important it is to have your emergency fund in place.
2. Pay Off High Interest Debt
By only paying the minimum on your maxed out credit cards, you’re shelling out way more than you should.
Let’s assume that you have balance of about $2,461 on your credit card with an APR of 12.24%. If you make no additional charges, and each month you only pay the required minimum of $50, you will pay off the balance in — get this — 17 very long years! Even worse, you’ll end up paying a total of $4,753, or nearly twice what you originally owed!
Be smart and pay off those high interest credit cards pronto.
3. Max Out Contributions to Retirement Accounts
In 2014, workers and their employers averaged $9,670 in 401(k) contributions. While this number may seem impressive, keep in mind that the contribution limit in 2014 was $17,500.
There is still a lot of room for improvement in our nest eggs. This year, there is even more. In 2015, the IRS bumped up the contribution limit for 401(k) and profit-sharing plans to $18,000. For those age 50 and over, you are permitted to make an additional catch-up contribution of $6,000 to traditional and safe harbor 401(k) plans, and $3,000 to solo 401(k) plans.
Making out your contribution to your retirement accounts is also a great way to defer income taxes until retirement, when you’re more likely to be in a lower tax bracket.
4. Start Saving for College
Data from the U.S. Department of Labor shows that workers with four-year college degrees have an hourly rate earning 98% higher than people without a degree. The same data shows that the gap is continuously increasing over time.
This means that saving up for your, or your kids’, college education is a smart thing to do with your commission check. A good way to save for college is via a 529 college-saving plan, because in 34 states and the District of Columbia, you can receive a state income tax deduction for your contribution.
To make sure that your higher education investment pays off, double check the market value of your or your child’s college diploma. Some degrees aren’t worth their cost.
5. Get Better Banking Options
Your lucky windfall could unlock some better banking opportunities.
- By maintaining a larger account balance, you could qualify for a better interest rate. For example, my credit union currently offers an annual percentage yield of 0.20% for balances below $25,000, 0.25% for balances between $25,000 and $99,999, and 0.30% for balances over $100,000.
- Depending on your financial situation, you may not have access to free checking accounts. Make use of your bonus to pad your checking account and meet the minimum threshold for avoiding any fees.
- Determine if your bank can offer you a better deal with a larger account balance. If your bank can’t provide you one, it’s time to shop around for a better financial situation.
6. Prepare for Taxes Next Year
Last but not least, it can be wise to start preparing for next year’s tax season now.
- Your year-end bonus may put you in a higher tax bracket this year. Ask your employer if he or she can defer your bonus (or at least a portion of it) in order to lower your tax bill this year.
- Keep in mind that most employers opt to slap a standard 25% withholding rate (39.6% for amounts over $1 million) on bonuses and commissions. If your usual tax rate is far below that 25%, then you may already have paid enough in taxes this year. You’ll need to adjust your W-4 form to decrease how much is withheld for taxes for the rest of 2015.
- Ask your human resources department which withholding option works best for you. Besides the standard withholding rate, the IRS allows employers to treat the bonus as regular compensation or take additional taxes only from the bonus check.
Every year, 75% of U.S. taxpayers withhold too much tax. Don’t become one of them and plan ahead. You want to enjoy as much as possible from that well-deserved bonus or commission check.