How to Make Your Bonus Work for You

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So, you’ve received your annual bonus, an inheritance, or a lump sum of cash that you’re looking to contribute to your financial picture. Now what?

If you find yourself in this situation, you should begin by looking at your overall financial picture. Is there debt you could pay off? A rainy-day fund you could build? Are you saving to put a down payment on a house? While it may be tempting to go on a spending spree, you’d be wise to look at your overall financial picture first. Here are 5 steps to follow for how you should responsibly allocate a lump sum of cash.

1. Build a Budget

Forgive me for mentioning the B word, but the most important piece of building a solid financial plan is learning to budget and allocating your dollars ahead of time to ensure that you’re living within your means. This is true on a monthly or annual basis, just as with a bonus or other lump sum of cash. It is human nature to spend frivolously if the money is at your fingertips, but planning out how you will distribute the funds ahead of time can help you to use them wisely and live by your budget.

2. Pay Off Debt

If you have any non-mortgage debt, consider using your bonus or other lump sum to tidy up your balance sheet. This is especially important if it’s expensive debt, as it would be unreasonable to assume that your investments could outperform a credit card that was charging 15% interest. On the other hand, if you have, for example, a small car loan at 2 to 3%, you could make a strong argument to keep that. However, behavioral finance advocates would argue that although your investments could likely outperform the 2 to 3% interest rate, your financial picture would improve if you no longer had that monthly payment and instead were able to allocate those surplus dollars towards your investments. Behavioral finance is certainly one of those situations where 1+1 does not always equal 2.

3. Create Your Emergency Fund

If you have used your bonus to pay off your debts and still have surplus dollars, you should then advance to funding your emergency stash. A good rule of thumb is to have enough money set aside to cover 3 to 6 months of expenses, but this should be dependent on what type of work you do. If you have variable income, you might consider holding more than six months of cash. The intent of an emergency fund is to act as a buffer between an unforeseen liquidity event and your investments. It’s fine for your emergency fund to lose purchasing power against inflation, but you should mitigate that as much as possible.

4. Bolster Your Retirement Savings

Consider carving out a portion of the lump sum to put towards retirement savings. The precise amount will be dependent upon your age, your financial objectives, and your current savings, but 10-20% is a good rule of thumb. You could save this in an IRA or a Roth IRA, or you could bump up your contribution to your employer-sponsored retirement plan on the paycheck that your bonus hits. Consider using the rule of 72, where you take 72 and divide by your estimated annual return to determine how long it would take your money to double. For example, if you could get an 8% annualized return, it would take your money about nine years to double (72/8% = 9 years). To put it another way, if you waited nine years your bonus could have double the effect, if you waited 18 years, 4 times the effect, and 27 years, 8 times the effect. Warren Buffett called this—compound interest—the 8th wonder of the world.

5. Spend Some

If you have gone down this list and find that you still have some dollars left over, don’t feel bad spending them on something fun, like a trip, a home remodel, or a new car. After all, the reason that you develop a financial plan is so that you can spend your money on the things that you want and need. Your financial plan should be a living, breathing thing that evolves as you do.

If you’ve recently received or expect to receive a bonus, inheritance, or other lump sum of money, we hope this list helps you stay on track. If you’d like a second opinion on how to allocate your funds, please don’t hesitate to get in touch with our team. We’re here to help you navigate your financial journey every step of the way.

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