Should I put part of a generous bonus into my 401(k) account?

Question

I am about to get a good bonus, should I take it all or let part of it go into my 401(k) account? Is it any different than if I decide to put similar amount of money in 401(k) at some other time of the year?

Answer 1

Is it any different than if I decide to put similar amount of money in 401(k) at some other time of the year?

Not from a tax standpoint, but if can affect a few other things:

• You will start earning returns (or face losses) earlier if you take it out of your bonus now versus take it out from future paychecks
• If your total contributions including your bonus contribution will hit the annual maximum, you will hit that ceiling earlier and stop future contributions. (e.g. you might not have any 401k taken out in December)

Since the earnings difference is likely negligible (you miss out on returns for only a few months), I would look at other conditions -

• Do I have any debt that I can pay off with the bonus versus investing it?
• Do I have enough in an emergency fund or should I use the bonus to fund it?
• Do I have other saving/spending goals that I want to apply it to (college, next car, down payment on house, etc.)

In the long run it probably won't make much difference, but knocking out obstacles to wealth building can give you a sense of accomplishment that will encourage smart money decisions going forward.

Answer 2

One factor to consider is that some employers have a 401k contribution match policy that only allows a certain percentage of any given paycheck to be matched. So if the company is willing to match 4% of each paycheck, you could run into a problem here where you lose out on some of your company match.

For example, suppose you get a $20,000 bonus. You can contribute $18,000 per year to your 401k and this bonus could be a nice way to knock most of that out and then take home your full paycheck the rest of the year. Sounds pretty nice, but there's a problem. The company will only match 4% of your $20,000 ($800) when they otherwise would have matched up to 4% of your annual salary ($4,000 if you're making $100,000 in this example).

I'd say it's definitely worth it to make a big contribution to your 401k when you get a bonus as it's an easy way to get a lot of money in there without really feeling a loss (since it's extra money on top of your normal paycheck). But I'd definitely be careful about this situation. You don't want to throw away free money. To avoid this problem, make sure that you leave enough of your annual limit so you can contribute enough to get your 4% company match on every paycheck of the year.

Answer 3

If you aren't already contributing the maximum allowable amount, by all means do so.

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If you are already contributing the maximum, it doesn't matter that much when you make those contributions. Making fixed monthly contributions is done mostly for budgeting reasons. Most of us can't predict fund performance well enough to optimize our contributions (by which I mean, contributing more early if you think the market is going up, but waiting if you think it will go down, following the "buy low" strategy).

As for employer matching, check with your company to see how they compute matches. They may match contributions for the year, even if those matching funds are only paid up to a maximum per paycheck. (For example, if you contribute 200% of the match for the first 6 months, then contribute nothing for the remaining 6 months, you may still receive the same matching funds per pay period as if you were contributing 100% throughout the year.)

Answer 4

Keep in mind one possible gotcha on depositing a bonus into your 401K: Tax withholding. Depending on whether your employer combines your bonus onto a regular paycheck, you can be bitten if you allocate a large chunk to your 401K.

I suspect your bonus is, like most, subject to an arbitrary federal withholding requirement of 25%, and if you allocate 100% of the bonus to your 401K, the 25% withholding may come out of what would ordinarily be the take-home in your "regular" paycheck - leaving you with a literal take-home of zero for one pay period.

There are lots of variables in that calculation, obviously, but it's one a lot of people seem to overlook.