Do bonus go into 401k?

When employees get a bonus outside of their regular compensation, they may get excited by the unexpected income and treat it as extra money outside of their regular income. To use the bonus wisely, you must consider all possible options of investing the bonus to maximize its value. In this guide, we consider how bonuses are taxed and key investing strategies-including adding the bonus to 401(k), to make the money work for you.

You can add your bonus into your 401(k) to defer paying income taxes until when you withdraw the money. Depending on the size of the bonus and how much you have contributed to the 401(k), you can contribute part of or all of the bonus into a 401(k) to maximize its value. However, if you contribute too much of the bonus, you could hit the annual contribution limit too soon and miss out on company matches.

How are bonuses taxed?

The IRS considers bonuses as supplemental income for tax purposes, and they are not simply added to your taxable income and taxed at the ordinary tax rate. Instead, the bonuses are subject to a flat rate federal withholding of 22%, or 37% if the bonus exceeds $1 million. For example, if you earned a $10,000 bonus, the employer will withhold $2200 and send it to the IRS.

When paying the actual taxes on bonuses paid out to employees, employees can opt to use the percentage method or the aggregate method. For the percentage method, the employer will issue the bonus and impose a 22% withholding tax on the money- this tax will be withheld and sent to the IRS. If the employer opts to use the aggregate method, the employer will issue the bonus alongside your salary, and the total compensation will be taxed at the normal tax rate, which could be lower or higher than the 22% withholding tax rate.

Can a Bonus Go into 401(k)?

Before you add the bonus into your 401(k) account, you should check with your employer to know if this is allowed. Most often, the employer will not place restrictions on what you can do with the bonus, but some employers may deny employees the option of contributing their bonus into the 401(k) account.

Typically, if your employer allows you to contribute bonuses into 401(k), the 401(k) plan may be set to deduct a percentage from your bonus at the same rate as your paycheck. Therefore, if you defer 10% of your salary to your 401(k), your employer could defer a similar amount from your bonus and deposit it to a 401(k) account. For example, if you earned a bonus of $10,000, only $1000 will be added to your 401(k) account.

However, a potential issue of contributing a percentage of your bonus to your 401(k) is that you can hit the IRS annual contribution limit before year end. For 2021 and 2022, you can contribute up to $19,500 or $20,500 respectively. If you hit the IRS cap too early, you could miss out on matching contributions from your employer in the remaining months of the year. You should avoid making excess contributions to the 401(k) since you could pay a penalty for each year the money remains in excess.

Other Ways to Use the Bonus

Here are other ways to strategically use the bonus to boost your finances:

Contribute to multiple retirement accounts

If you contribute up to the IRS limit for 401(k) contributions, you can channel the remaining bonus to a traditional IRA, Roth IRA, or other retirement accounts. If your bonus is more than your 401(k) can accommodate, you can add the excess amounts that remain to an IRA. Usually, once you max out your 401(k) contributions, you can contribute the additional amount to an IRA up to $6,000 per year, or $7000 if you are 50 or older.

If you have a Roth IRA, you will pay taxes on the contributions you make, but future withdrawals will be tax-free. If your income exceeds the IRS limits for Roth IRAs, you can use the Backdoor Roth IRA strategy. This strategy involves making contributions to a non-deductible IRA and then converting the account into a Roth IRA.

Pay down high-interest debt

If you have high-interest debt like a credit card or personal loan that is weighing you down, you can use the bonus to settle these debts. For example, if you have a $10,000 credit card balance with a 21% APR, and you are expected to pay it down in 15 months, you can use the bonus to eliminate this debt in one payment and save money that would otherwise go into paying interest rates. Also, you will have one less debt to deal with, and you will free up more money to go into investments.

Contribute to an emergency fund

If you don’t have an emergency fund, you can use the bonus to create an emergency fund to cater for unexpected expenses such as a medical emergency or when your car breaks down. Financial advisors recommend setting aside six months’ worth of savings.