Oh, the age old question: What to do with a year-end bonus? If you get one. And if you do, this year, it will probably be smaller than usual. But still. What to do with it?
It’s so tempting to rush out and spend a year-end bonus on gifts for your family and yourself. After all, it’s been a ridiculous year and you deserve a treat. Go ahead, but limit your spending to 10 to 20 percent of the bonus.
For the rest, consider putting it in an emergency high-yield savings account to help out if the economy worsens. Another idea is to contribute to or open an IRA.
IRA For Independence
Opening and regularly contributing to an IRA helps you establish some degree of financial independence apart from an employer-sponsored retirement plan. Plus, you may choose from a much larger range of investment options, including a stock and bond portfolio, any number of mutual funds, Real Estate Investment Trusts (REIT), and Exchange Traded Funds. Using a year-end cash windfall is a great way to start the New Year. Also consider setting up an automatic investment plan so you can contribute a small amount each month throughout next year.
If you don’t already participate in a company-sponsored qualified retirement plan, you may deduct your IRA contribution (up to $5,000 for 2009; $6,000 if you’re 50 or older) right off your tax return. In addition, your IRA assets grow tax-deferred, meaning you don't have to pay taxes until you withdraw money in retirement, when you’re more likely to be in a lower tax bracket.
Alternatively, you may choose to open a Roth IRA. With a Roth, you don’t get a tax deduction on your contributions, but after age 59 ½ (as long as you’ve held the account for at least five years) you may withdraw earnings tax free. Not a bad alternative if you’re participating in a 401(k) or 403(b) at work.
Time to Buy and Sell Investments
Sell some of this year’s investment losers to offset taxable gains on any investment winners, and use the cash to reposition your portfolio for stronger performance next year. You’ll need to cash out before December 31 to get the offset tax benefit. When selecting which investments to sell, consider these tax tips:
- Investments held one year or less are considered short term with gains taxed at ordinary income rates.
- Investments held over one year are considered long term with gains taxed at 15% (scheduled to increase to 20% in 2010).
What should you do with the extra cash? Reinvest. Since 1929, the best month for the S&P 500 has been January. Additionally, small-cap stocks have outperformed consistently in the month of January over the past 70 years—a phenomenon called the “January Effect”. If you buy in December you have time to position your portfolio to take advantage of the potential January run.
Do you get any income—or are you attempting to make some income—from a venture that you started as a hobby? Maybe you sell knitted scarves at community bazaars, referee youth sports, or offer after-school tutoring. Any supplies and expenses you incur may be eligible tax deductions, even if you don’t turn a profit. Consider, too, that driving to and from this hobby-related work is tax deductible as well, so keep a record of your miles.
If you’re the person responsible for running errands at work, such as Post Office runs or trips to the office supply or grocery store, any unreimbursed travel expenses may be deducted on your personal tax return.
Do you receive student loan assistance for a child in college? If so, you may take the Tuition and Fees deduction on money borrowed to pay for qualified college expenses in the year that the expenses are paid (as opposed to the years when the loan must be repaid). This deduction is up to $4,000 a year and is only for tuition expenses paid by the taxpayer. Bear in mind that, currently, this is the last year (2009) this deduction will be available.
Earmark Windfalls For Specific Expenses
And thus, the age old question remains: What to do with a tax refund? How about earmarking your next tax refund to pay for a specific expense that tends to eat away at your monthly income, such as a credit card balance, your auto insurance, or even next year’s childcare expenses.
This is a good idea even if you participate in a Dependent Care Flexible Spending Account (FSA) at work. The way an FSA works is that you specify an amount to be deducted from your paycheck each month into an account before any taxes are deducted. Then you pay the qualifying expenses—childcare or health care—out of your own pocket. Then you send in the receipt and are reimbursed by this account with tax-free money.
Participating in an FSA requires strict discipline, because it feels like you get hit with the same expense twice—at least until you get reimbursed. When you get used to living on less, the periodic reimbursement can feel like “free money.” In lieu of spending this money precipitously, use it as a contribution to your IRA or other investment account. If you wonder how you can squeeze extra money out of your income for investing each year, there it is. It just requires learning to live on less and the discipline not to spend reimbursement checks frivolously.