The Case for Putting a Bonus Into a 401(k)
What You Need to Know
Stocks are cheap and contribution limits have jumped, making 2023 a great time to invest that annual payout for the long term.
Making the most of a bonus is always important, but 2022’s payout feels even more precious. Many workers, especially in finance and technology, are likely to see slimmed-down bonuses. Amid economic uncertainty, maximizing those dollars is crucial.
But should you sock away as much as you can in a tax-deferred retirement account to minimize the tax liability? Or keep the money somewhere accessible and liquid so you have cash on hand for any emergencies? Or use it to pay off debt?
There may be situations where it’s better to use a bonus in the here and now, like paying off high-interest credit-card debt. But if you have a relatively low interest rate on your debt — like a fixed-rate mortgage — using a bonus to pay it down doesn’t necessarily make a whole lot of sense.
For most people, prioritizing retirement contributions is the better course of action. And one benefit of maxing out a 401(k) early in 2023 is that it’ll enable investors to get in while the market is still down and stocks are cheap, says Mike Wren, a certified financial planner at Legacy Financial Strategies.
Tax Matters
There are also tax advantages. Your bonus is generally taxed at the same rate as the rest of your income. Employers often withhold a flat rate of 22% if the bonus is under $1 million (if it’s more than $1 million, then it’s 37%).
For workers subject to income tax rates above 22% (meaning they make more than $95,375, or $190,750 if married and filing jointly) then too little will be withheld and they’ll owe more come tax time.
Unless, that is, you put the bonus money in a tax-deferred retirement account. Then that bonus isn’t considered part of taxable income when calculating income taxes. (You’ll still owe Social Security and Medicare taxes on any bonus money that goes into a 401(k), according to Eric Bronnenkant, head of tax at online financial advisory firm Betterment.)
Thanks to inflation, contribution limits have risen. For 2023, those under 50 can put up to $22,500 in a 401(k) (a $2,000 increase from last year) and workers who are 50 and over can put in $30,000.
