Ahhh, it’s that time of year again. Colder weather (unless you live in California), seasons change (unless you live in California), and the holidays arrive (California still has those, thankfully). We can usually count on the last few months of the year to bring some excitement to our lives, whether it’s genuine excitement like seeing family we don’t normally see, or “drama” excitement…like seeing family we don’t normally see.
If we’re lucky, sometimes the end of the year brings us some sweet financial excitement, like a bonus from work or a healthy “I love you!” cash infusion from Gam-Gam. It’s nice to know people.
I get a lot of questions from friends and young professionals about what to do with this money when it comes in, which is great. I’d rather hear, “I just got a $10,000 bonus and don’t know what to do” than “I just got a $10,000 bonus and I bought bitcoin and went to Vegas!”
The questions usually revolve around how to divvy up the cash inflow in the most productive way possible, so I’m going to pose some absolute things to do as well as some things to think about here in this article that will hopefully help guide your next large cash inflow.
Navigate to what you need:
- Always, Always, Always…Pay Yourself First
- Now, It’s Time to Celebrate!
Always, Always, Always…Pay Yourself First
I find it strange that most of us are willing to pay everyone else before we pay ourselves. Could you imagine if our employers did that? Paid all the bills EXCEPT salaries and no one got compensated?
Spending our money before saving is the exact same thing. We should strive to pay ourselves first, in the form of paying down debts or saving, and only then should we splurge on ourselves. We cover our bases so that “future me” isn’t picking up the pieces that “today me” left behind.
The percentages recommended are just that: recommendations. There are no hard and fast rules, but use the actions laid out below as guidelines to help yourself get started.
To-Do #1: Pay Down Debts
Most of us have a car with a loan on it, or furniture in our apartment or home that isn’t fully paid off yet, or student loan balances remaining. It’s okay to initially have debt like this in the sense that it helps to improve our quality of life, at least in theory. I need a car to get to my job every day, I like having somewhere to sit in my apartment, and my higher education advances my future career prospects.
However, as long as we have these debts, they are the primary source of quicksand our paychecks are subject to (aside from the U.S. government). This means less money going into our pockets because somebody else has a claim on our money that trumps our own claim on it.
Attitude Towards Debt Determines the Payment Method
When paying off debts, it’s important to understand our attitude towards the balances. Does the dollar amount bother us the most, or do the interest rates? There are two different methods for paying down debt and they revolve around the answers to this question: the snowball and avalanche methods.
If the dollar amount bothers us, then we need to pay off the smallest loans first to feel a sense of accomplishment. This is the snowball method. Once we pay off a balance, we roll the payment onto the next lowest balance and continue until all debt is paid off.
If the interest rate bothers us, then we need to pay off the highest interest rate loan first. This is the avalanche method. This works for people who don’t like paying more money than they originally borrowed and are disciplined enough to stick with the payments, even if they don’t see any debt balances going to $0 in the short run.
ACTION: Decide how you feel about your debts and choose the method above that will best address your situation, and use 25% of your funds to pay them down.
To-Do #2: Fund Emergency Savings Account
Sometimes paying ourselves is as simple as having cash on hand to solve our immediate problems (not stuffed in our mattress or buried in the backyard somewhere, though). I talked in a previous post about the importance of having an account that has sufficient cash reserves for the inevitable “uh-oh” moments in life, and I’m going to reiterate that point here.
Funding this emergency account should be your next priority after paying down some debt. If you don’t have an emergency account, open a second checking account and get started.
How Much is Enough?
The general rule of thumb is to have 3 or 6 months of expenses sitting in cash. So, how do you know which is the right amount for you?
Ideally, if you’re single and have multiple income streams or are married with two solid incomes, then 3 months of expenses is probably sufficient. It’s easier to withstand hardships if multiple revenue sources are involved, so fewer reserves are required.
On the other hand, if you are single or married with one source of income, then 6 months is an appropriate amount. A salary decrease or job loss is much more impactful if there is only one income source, so it’s smart to have a larger amount of dry powder on hand.
ACTION: Determine if you need 3 or 6 months of expenses in cash based on the criteria above and set that as a goal, using 25% of your bonus funds as a baseline.
To-Do #3: Contribute to Tax-Advantaged Accounts
A tax-advantaged account is so important to a financial plan because it allows us a tax break either today or in the future, or sometimes both. Congress designs the tax code around incentive structures so we’d be wise to take advantage of it where we can.
After we’ve paid down some debt and/or beefed up our emergency savings, we should look next to invest in tax-advantaged ways.
Fund a Roth IRA
In 2022, if we are single and make less than $129,000 ($138,000 in 2023) or are married and have a joint income less than $204,000 ($218,000 in 2023) then we are eligible to contribute directly to a Roth IRA. We are allowed a max $6,000 contribution ($6,500 in 2023) if under age 50, and $7,000 if we are over age 50 ($7,500 in 2023).
We always have access to our contributions in a Roth IRA because we contribute after-tax money into the account. Uncle Sam has already had his tax bite on those monies, so we’re allowed to withdraw our contributions if need be. This could act as our “backup” emergency account if we really had a tough day, but these monies generally should never be tapped.
The next decision we have to make is how to invest our Roth IRA.
When we’re young and building up our asset base, it’s hard to get the proper diversification needed for a balanced portfolio simply because we don’t have enough money to spread around. Fortunately, it’s easy and cheap these days to put our money in an S&P 500 index fund and have access to thousands of companies inside one wrapper. This could be a place to start.
I’m not making any specific investment recommendations here, but I do recommend staying diversified if possible.
Fund an HSA
A Health Savings Account, or HSA, is a triple tax-advantaged way to save for healthcare expenses. It requires a High-Deductible Health Plan (HDHP) and allows us to contribute tax-deductible money into the account, invest it and have the earnings grow tax-free, and take it out of the account at any time for qualified health expenses, tax-free.
If we are single, we are allowed to contribute up to $3,650 ($3,850 in 2023) if under age 50, and $7,300 ($7,750 in 2023) if we are married and under age 50 in 2022. There are no income limits with HSAs, and just like the Roth IRA, there is a $1,000 catch up contribution allowed for those over age 50.
I will be writing a future post about the intricacies of HSAs but for now, if you have a HDHP and do not require consistent medical care, then an HSA could be a great fit for you. The investment options in an HSA are the same as a Roth IRA so I’d recommend investing them both the same way if you can.
Fund 529 Accounts
This may be a few years down the line depending on where you’re at in life, but 529 plans are great vehicles to kickstart college saving for a child, niece, or nephew. They are state-run savings plans that you fund with after-tax dollars and invest tax-free and withdraw tax-free for qualified higher education expenses (this tax treatment is similar to a Roth IRA, except the 529 funds have to be used for school expenses to receive the favorable tax treatment). The investment options are limited and are provided by the specific state the plan is in, but they tend to be broadly diversified funds.
I’ve only scratched the surface on the power of 529’s and it’s probably best to have a 529 at the bottom of your “paying myself first” list, but it is worth mentioning due to all of its great features.
ACTION: After paying off any debts and funding the emergency account, determine which of the above account(s) applies to your situation and set aside 25% of your funds to contribute.
Now, It’s Time to Celebrate!
To-Do #4: Treat Yourself!
Either you worked hard at your job to deserve the bonus, or you worked hard to get in Gam-Gam’s good graces to receive a cash gift from her, and in either case, you deserve to treat yourself!
The sooner we take care of our financial futures, the more flexibility we have to do the things we want in life. I’m a big believer in controlling our finances so they don’t control us, and that’s what the first 3 to-dos in this list consisted of.
But I also think it’s important that we reward ourselves for our hard work, recognizing that it’s okay to spend money on ourselves sometimes. As long as we cover our bases and take care of our future selves first, it’s perfectly reasonable to splurge a little.
Take a look at your budget and see how much you’d be comfortable spending on yourself. This could be new golf clubs, a mini vacation, a spa day, or a steak dinner. There’s no right answer on what constitutes “treating yourself”, but it’s unwise to spend more than your remaining bonus funds on whatever it is that you want (unless specifically budgeted for).
ACTION: Use your last 25% of your bonus to do something for yourself!
Year-end bonuses obviously improve our financial situations almost instantaneously, if we allocate the funds correctly. They tend to not be so useful if we take them to Vegas for a weekend, put it all on red, and wake up Monday morning not remembering what happened.
It’s important that we practice a bit of delayed gratification and first take care of the basics and help to ensure our financial longevity before splurging on gifts for ourselves.
But this doesn’t mean that we can never splurge, because we should! I think the beer ad disclaimer “please drink responsibly” applies here: treat yourself, but do so responsibly. Congratulate yourself on the hard work and have fun!