Maximize your bonus with the help of a 401k / 403b
A lot of employers are giving cash bonus to employee’s instead of raises (saves the company money) I like it too, but a salary raise will pay off more in the long run.
Question: How do I get the most money when the tax man takes about 42%?
Well, the only solution is to do as many pre-tax withdrawals as you can.
List of possible pretax withdrawals
- 401k / 403b contribution
- Not ROTH (after tax dollars – doesn’t help)
- IRA
- Not ROTH (after tax dollars – Didn’t help above still won’t help here)
- This one is a little sticky because you get the tax rebate at tax time (April 15th) not at payout time
- Health Savings Account (HSA)
- Anything else your employer offers
Example break down, what do the numbers look like?
- Assume a person gets a salary of $50,000 a year paid by weekly (26 payments)
- Person gets a 10% bonus
- Tax is 42% on a bonus (varies state to state, though it is higher than normal salary)
- The company matches dollar for dollar up to 3% (varies company by company) and won’t let you contribute more than 25%.
|
Salary |
$50,000.00 |
$50,000.00 |
| Bonus |
10.00% |
10.00% |
| Bonus |
$5,000.00 |
$5,000.00 |
| 401(k) % |
25.00% |
3.00% |
| 401(k) Personal |
$1,250.00 |
$150.00 |
| 401(k) 3% match |
$57.69 |
$57.69 |
| 401(k) Total |
$1,307.69 |
$207.69 |
| Remaing |
$3,750.00 |
$4,850.00 |
| |
|
|
| Tax % |
42.00% |
42.00% |
| Tax |
$1,575.00 |
$2,037.00 |
| Bonus |
$2,175.00 |
$2,813.00 |
| |
|
|
| Bonus + 401(k) |
$3,425.00 |
$2,963.00 |
The above table covers two options:
Option 1 (25% max contribution on bonus)
- Contributes $1,307.69 to a 401k
- ($1,100.00 more than option 2)
- Cash payout is $2,175.00
- (-$638.00 less than option 2)
- Total payout $3,425.00
- ($462.00 more than option 2)
Option 2 (3% to meet company match)
- Contributes $207.69 to a 401k
- (-$1,100.00 less than option 1)
- Cash payout is $2,813.00
- ($638.00 more than option 1)
- Total payout $2,963.00
- (-$462.00 less than option 1)
Summary
With a company matching contribution (3% in example), you get more cash in pocket. However, your Adjusted Gross Income (AGI) is higher for the year and you get less in retirement savings.
Maxing out your contribution (25% in example) gives you $462 more overall and lowers your AGI by $1,100. That $462 appears again because that is how much less you paid in taxes initially. Plus you will pay less in taxes when the tax man cometh.
Maxing out your contributions is the best overall plan.
- Lower AGI
- Lower Taxes
- Higher Retirement Savings
- Maximum long term money to you
I mentioned above that you can also contribute to HSA (another way to lower your AGI). The trick is changing your contributions for your HSA requires a lot of paperwork. Harder to do… is it worth it?
No matter what you decide to do above; you can also take the cash payout and contribute to an IRA. But that tax credit comes during federal tax time. Good plan, but you have to wait longer to see dividends.
Lastly, remember ROTH options are not useful to avoid the tax man. As all ROTH contributions are post tax dollars. ROTH accounts are great for long term retirement planning (because no one can predict your tax exposure at retirement time and having a tax free income stream could be useful), just not the best option for a bonus.
Overall, the goal is to get the most money to you, just not necessarily cash burning a hole in your pocket.