There are very few workplace experiences that are more fun than finding out you’re getting extra income. Whether it’s a bonus, a few extra commissions or a promotion with a hefty salary increase, finding out that you’re going to have extra income is a great feeling.
But you also need to make sure you divert that extra income to the right goals. You can accelerate your progress towards your long-term goals like retirement by making smart choices when a windfall comes. Here are some tips that may help you take the right action.
Go Ahead, Pop the Cork
Hey, you’ve earned it. Treat yourself and your loved ones to something enjoyable – a fancy dinner out, a weekend away, whatever grabs your fancy. The good life is about small, special moments that you enjoy.
Just don’t get carried away. Spending $100 on a nice dinner to celebrate a $5,000 bonus is probably fine, assuming you’re not trying to dig yourself out of debt. But don’t blow your bonus on a boat, flat-screen TV and a weekend in Vegas. You’ll need that money to achieve your long-term goals.
Determine Your Priorities
Broadly speaking you have four major spending and saving categories:
1. Necessities like rent, groceries and gas
2. Discretionary spending like eating out, vacations and gifts
3. Rainy-day savings for unexpected emergencies
4. Investing for goals like college educations, retirement and estate planning.
Identify which areas need attention, and focus on those. If you don’t have a rainy-day fund, for example, use your extra income to set up a cash reserve that you can tap in case of emergency.
How can you identify where to put your extra money? One popular method is to review your spending from the past few months, by looking over your credit and debit card statements and your bills. Note the proportion of your income that you’re spending on necessities, discretionary purchases, and savings and investments.
As a general rule of thumb, no more than 50 percent of your income should go towards necessities, 30 percent towards discretionary spending, and 20 percent or more towards savings and investments. If you haven’t reached that 20 percent threshold for savings, you should review your goals and determine what is most important to you.
Many people rush right out and spend their extra income on some item on their discretionary spending wishlist, such as a new refrigerator with all the latest gadgets or a down payment on a new car. It may be a better decision for the long-term, though, to think about how you can improve your retirement plan.
Invest Your Extra Income Towards Long-Term Goals
If you’re like many people, you are invested in a retirement plan through your company. Also, if you’re like many people, you aren’t contributing up to the maximum amount allowed by the IRS (typically $17,500 annually for an individual 401k or 403b plan). Can you increase the amount you contribute every month? Or can you apply your extra income – your bonus or windfall – towards maxing out that contribution? (More on that below).
At the very least, you want to maximize your employer match. Or maybe you want to open an Individual Retirement Account, or IRA, as a second account for retirement income. You can invest up to $5,500 annually – a perfect destination for some of that extra income.
In addition to retirement, you may have other goals that you haven’t been able to fund to the level you want. If you have kids, you know that college educations are going to be a reality sooner than you think. Maybe this is the right time to set up a 529 college savings plan. (Again, more on that below).
Extra money can certainly make life easier, but it is also a responsibility. Make sure you think through your options when it’s time to invest that extra income.
How Do You Actually Invest This Money?
Let’s imagine that you decided to reach your 20 percent savings/investments goal by investing your entire bonus, commission or other source of extra income. How do you actually go through the process of making this investment?
First, choose the purpose of the investment. Is this for retirement? College savings? Savings for a rainy day? You’ll choose a different type of account based on the purpose of the money.
As a closely-related second step, decide how long you’re going to keep the money invested. This decision will guide the way in which you invest your extra money. If you’re saving for a rainy day, there’s a chance you might withdraw that money in six months or a year. In this case, you want to “play it safe” by keeping that money highly “liquid” – meaning, in cash.
If you’re preparing for a long-term goal like college or retirement, though, you’ll want to choose longer-term investments that have a greater likelihood of growing and appreciating over time, such as stock mutual funds, index funds or exchange-traded funds. This will help you beat inflation and can result in extra money in your pocket!
But you shouldn’t put ALL your money into a stock fund. After all, the market is volatile, You want to smooth out the “bumps” by diversifying your investments into an array of equities, bonds, cash and commodities. (More on that in Step 4).
Third, open an account that’s designated for the purpose of the investment. If you’re saving for a long-term goal, open an account that will allow you to make tax-deferred or tax-exempt contributions. This simple step alone can help you save thousands on taxes, which results in even more extra income that you can invest and ultimately more that you will have for your goal.
If you’re investing for retirement, open a 401k or IRA. If you’re saving for your child’s college fund, look into a 529 College Savings Plan or another state-sponsored tax-advantaged college savings plan. If you’re saving for emergencies, open a savings or money market account at your local bank, which doesn’t have any tax advantages but can easily be tapped in the event of an emergency.
Fourth, decide how to diversify your investments among different asset classes like stocks, bonds and other options. Your asset allocation will be based on your goals, risk tolerance and other specific, highly individualized considerations. If you need help, sign up for an account with Jemstep’s Portfolio Manager, which can show you a custom-tailored investing portfolio for your personal goals and style.
Fifth, find funds for each asset class. You’ll want to look at factors like fund fees , management style and performance. Jemstep’s Portfolio Manager can give you specific buy-and-sell recommendations to help you find those funds.
Have you gotten some extra income recently? What are you going to do?
For investment advice and practical tools about how to invest your income, extra or otherwise, visit Jemstep.com.