If you have a nice chunk of extra cash to look forward to each year, think now about the best ways to put it to work for you.
Maybe this year you’ll get lucky. You’ve applied for that great, higher-paying promotion and this will boost your monthly pay by $500. You want to make sure the money goes toward building a better future rather than being squandered on items, you just don’t need.
That’s the beauty of getting a year-end raise or bonus-it’s one of the rare opportunities to make a big difference in your finances without having to make sacrifices. You’ve been living without the money previously, so you can take any financial medicine you need even without altering your present lifestyle.
Financial triage
Consider first that all extra cash should first be used to solidify your base.
Next, pay off all credit-card debt.
This can have a gigantic ripple effect on the rest of your finances. As soon as you stop paying higher interest charges each month, you’ll have more money to devote to any other goals.
Pad your emergency fund, if you don’t already have three to six months’ worth of living expenses in a safe and liquid account. That way you won’t have to go into debt or raid long-term savings for unexpected bills when the bigger emergencies do arrive.
Add contributions to your 401(k), if you haven’t hit the limit. You’ll avoid paying more taxes on the extra cash, and you may earn free money if you get an employer match. You can also invest part of your bonus in your IRA if you haven’t contributed $3,000 for 2004 ($3,500 if you’re 50 or older). If you’ve already reached that limit, use your bonus to make your 2005 IRA contribution in January (the limit rises to $4,000 next year, $4,500 if you’re 50 or older) or earmark a bigger chunk of your raise each month.
Take a look at that long-term debt
Now that you have boosted your financial foundation, you have more flexibility. Watson is already in great shape-she’s maxing out her 401(k) and Roth IRA contributions-but she still has about $17,000 in student loans hanging over her head. The loans carry a low, 3.5% rate, so she’s trying to choose between adding the $500 a month to her loan payments or investing the extra money.
With interest rates that low, paying off the loan doesn’t need to be a priority. “If you can earn at least 3.5% in the marketplace, and I believe that you can, then investing is the better way to go,” says Brian Jones, a certified financial planner in Fairfax, Va. Investing becomes even more important if you need to save for a short-term goal, such as buying a house.
However, it’s okay if you’d rather pay off a student loan to get it out of the way. “Psychologically, it’s important to get these debts behind you before you start to move ahead,” says Mari Adam, a certified financial planner in Boca Raton, Fla. “I know people in their 30′s who still have big loans, and that debt becomes like a ball and chain around their leg.”
The same is true if you’re thinking of devoting part of your raise to making extra mortgage payments. Chris Crocket, a doctor in Tupelo, Miss., is getting a big bonus this year that could be enough to pay off his mortgage that has 10 years remaining at 4.75%. As long as he’s covered his other bases, paying off the loan could give him the equivalent of a guaranteed 4.75% return.
Eliminating your mortgage payment can also help if you’ll be retiring soon or worry that you may lose your job, says Evelyn D’Amico, a financial planner in Paoli, Pa. However, you don’t want to tie up too much money in a single investment. For better diversification, you could devote part of your raise or bonus to your mortgage and then invest the rest.
Don’t forget to treat yourself
It is time to have some fun and you deserve it! You worked hard for your bonus or raise, so, go out there and have some fun.
You can set up a vacation fund.
Use part of your extra cash today to pay for the trip you have always wanted. You only need to set aside $310 per month in a savings account paying 2% to end up with $5,000 for springtime in Italy in 2006. Imagine spending the spring in Italy! Now that would be some kind of vacation.
Spend some money on your home.
Many home improvements can save you big money over the long haul. For example, think about the value of storm-resistant windows and shutters. Spending an extra few thousand dollars now, not only helps protects your home, but also can increase its value and lower the premiums on your homeowner’s policy. This is smart planning!
One final idea is to start up a charitable fund. With $10,000, you can set up a donor-advised fund at many mutual fund companies and brokerage firms. You can then deduct the contributions on your tax return straight away and decide later which charities that you wish to support.
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