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Getting a holiday bonus? Where should the money go?

Whoo hoo!!! End of year bonus check and it couldn’t come at a better time. Unless you’re an investment banker (in which case you’d be getting a bonus in March not December) your end-of-year bonus is probably anywhere from 10-30% of your annual pre-tax pay, which can be a pretty nice chunk of change. What should you do first?

I like to think about saving as a cascade that fills one bucket then spills over to the next bucket once the first one is filled.  If you save in a cascade from most important and imminent to least important, you will always have savings where you need it when you need it.

Start with making sure your rainy day fund is filled. A Rainy Day Fund is $2,000-$3,000 per family of 4 ($1,500/individual) put away for the annoying stuff that happens. It’s for when you need a new refrigerator, some tires, child’s activity, tax bills you forgot about, and health insurance deductibles. A Rainy Day fund is NOT an Emergency Fund. Emergency Funds are for financial catastrophes like job loss, illness or disability.  Rainy Day funds are for things that come up and you end up whipping out the plastic which puts you in debt further and makes you feel more choked by your financial situation.

Second is retirement. The best time is when you get a lump sum like a bonus because you can also pay off other things and you’re not faced with a choice between retirement or paying down a credit card. If you can, max out your IRA contribution, or the amount your company will match for your 401k.

Third, pay down your credit cards if you have revolving debt on them. I’m not talking about people headed toward bankruptcy because that kind of debt requires a different plan, but if you are carrying an “acceptable” amount of debt (check your DTI ratio here) or few thousand dollars of revolving debt with an interest rate over 10%, pay at least 10% of the total amount of your bonus toward whichever credit card or loan has the highest interest rate or can be completely paid off with this one payment (See paying down debt blog post for details).

Take the remainder of your bonus and split it in half. Take the first half and spend it on stuff you want or need. Have fun and reward yourself for your hard work. No need to spend it all at once, but use the money for you and your family.  You may wonder why I’m so generous with my “me” amount? Well, if you don’t get to blow off steam every once in a while, you won’t stay with your plan.

Take the second half and save it! Either put it in your Emergency Savings, College, Vacation, or Home Improvement Fund. Or, add it to what you’ve already saved for retirement, or pay off more debt. Or my personal favorite, make an extra mortgage payment!

What you do with your bonus should look like this:

Pre-tax Bonus$15,000
Estimated Tax @ 30%$4,500
After Tax Bonus$10,500
IRA or Other Retirement$4,000
Rainy Day Fund$2,000
Revolving Debt Pay-off$1,500
Remaining Bonus$3,000
1/2 for YOU$1,500
1/2 in Other Savings$1,500