Investing Your Year-End Bonus

Remember Clark W. Griswold, Chevy Chase's character in National Lampoon's "Christmas Vacation"? He risked the lives of his wife and kids by stringing up a ludicrous number of holiday lights. A far worse blunder, however, was his plan to blow his entire holiday bonus on a backyard swimming pool.

Of course, I'm not privy to the Griswold family's financial records, so it's possible that Clark and his wife felt they could afford to splurge on a pool because they had already socked enough away to pay for the kids' college tuition and for a comfortable retirement. But at the risk of seeming exceedingly Grinchlike, it's worth noting your year-end bonus represents an excellent opportunity to enlarge your nest egg. Thus, you should think long and hard about spending it on something that falls into your "want" column (such as a pool or a tropical vacation) before you've saved everything you need to.

What to do with that year-end bonus is a pressing concern for more and more people these days. Once reserved primarily for corner-office types, bonuses are now an increasingly important component of compensation for those of us who are further down the food chain.

Handling your bonus wisely is also a higher-stakes proposition than it was in the past. That's because bonuses are increasingly supplanting annual pay raises as a means of rewarding employees. In lieu of perfunctory raises of, say, 3% a year, some firms are awarding bonuses instead, but only if an employee's performance exceeds a certain standard or if his or her company or department meets a certain financial target. If you work for a firm that is moving toward an incentive-based pay structure, you shouldn't consider your bonus an extra windfall, but rather a fundamental component of your pay package. You should also remember that the bonus money you earn this year might not be the same next time around, so it's particularly important not to squander it.

Even if your bonus doesn't actually replace your raise, it's essential that you invest it wisely. Read on for some of the best ways to make sure you get the most bang from your bonus.

Pay Down Debt
True, it's not an investing tip, per se. But before you put any money to work in the market, turn your attention to wiping out any debt on your books. With many market prognosticators predicting stock market returns in the 8% range over the next decade and bond returns at just half that amount, you're not likely to earn more on your investments than you're paying to service your debt. Carrying credit-card debt, which often has a sky-high interest rate, is an obvious no-no. But you might also consider sending an extra payment or two into your mortgage lender once your bonus check comes in, even though your mortgage interest rate is relatively low. By paying more on your mortgage than you're required to, you can shorten the life of your loan. For a detailed discussion on the pros and cons of prepaying your mortgage, check out this article.

Maximize Your Match
If you're highly compensated and your 401(k) contribution is getting deducted from your bonus, there's a chance you could miss out on some of the 401(k) matching contributions that your employer makes for you. That's because you're only allowed to contribute a certain dollar amount to your 401(k) in each calendar year. (In 2006, employees under age 50 can contribute $15,000, while those over 50 can contribute $20,000.) If you receive a big bonus early in the year and you're contributing a bigger percentage of your salary to your 401(k) than your employer is matching, there's a chance that you'll hit your dollar contribution limit well before the year is over. In turn, you won't be able to take full advantage of any matching contributions your employer would've made in the remainder of the year.

For example, say an employee who makes $100,000 a year is lucky enough to receive a $40,000 bonus in early 2006. If she's contributing 15% to her 401(k) plan and the company offers a dollar-for-dollar match on the first 10% of that contribution, she can no longer make additional contributions after her first $100,000 of earnings ($100,000 times 15% equals the maximum of $15,000). Her company match would be $10,000, or 10% of that $100,000. But if she lowers her contribution rate to 10%, she'll be able to contribute throughout the year and therefore will earn a 10% company match on the entire $15,000 contribution, gaining an additional $5,000 company match.

Check with your employer to find out whether your 401(k) contribution is being deducted from your bonus. If it is, you may want to lower the percentage amount that you're contributing to your 401(k) before you receive the bonus. In so doing, you'll ensure that your own contributions are spaced throughout the year, and you'll be able to take full advantage of your employer's matching contributions. (Bear in mind that some employers limit the number of times per year that you can change your 401(k) contribution percentages; check with your company's human-resources representative for details.) Calculating your own optimal percentage contribution with an eye toward maximizing your employer's match is tricky work. But some employers provide you with calculators that let you plug in your own salary, bonus, and 401(k) contribution percentages to ensure that you're taking full advantage of the available match.

Use the Money to Rebalance
We at Morningstar tend to be somewhat contrarian when it comes to investing, so we're naturally big fans of rebalancing--essentially, stripping away money from those assets that have performed well while putting cash to work in those that have not. Because you're sending new money to the cheaper stocks, bonds, or funds while cutting back on those that have seen the greatest price appreciation, rebalancing can lower your portfolio's overall risk level while improving its return potential.

The chief drawback to rebalancing, however, is that selling your winners from your taxable account can force you to realize taxable capital gains. That's why it makes sense to use your bonus money to get your portfolio's allocations back into whack; in so doing, you can circumvent the nasty tax effects associated with selling. Say, for example, you've determined that the five-year runup in smaller-cap stocks has left your portfolio decidedly light on large-company names. Rather than selling your small-cap winners, you could plan to deploy your bonus across your larger-cap funds or even add a brand-new large-cap offering.

To help determine the areas in which your portfolio might be light, check out Morningstar's Instant X-Ray tool. By entering each of your holdings in the tool and clicking "Show Instant X-Ray," you can quickly see your portfolio's breakdown among stocks, bonds, and cash; its industry weightings versus the S&P 500; and its dispersion across Morningstar's investment-style box.

Feed Your Tax-Sheltered Accounts
If you're eligible to contribute to a regular or Roth IRA and haven't yet made a contribution for calendar year 2005, you're apt to receive your bonus at an ideal time, as contributions are due by April 15, 2006. (You'll have until April 15, 2007, to make your 2006 IRA contributions.) Tax-deferred portfolios can grow more quickly than taxable ones, and the gains on Roth IRAs are tax-free.

To find out whether you're eligible to contribute to an IRA this year, check out Morningstar's IRA Calculator. To help identify the top funds to stash in your IRA, read this article and check out Morningstar's  Fund Analyst Picks. (Analyst Picks, which are our analysts' top choices across a broad range of categories, are available only to Premium subscribers of Morningstar.com; for a free trial subscription to our Premium service, click here.)

In addition, parents might also consider adding to or starting a 529 college-savings plan for their youngsters, or contributing to or starting a Coverdell Education Savings Account. Both allow you to save and make tax-free withdrawals for eligible college expenses. Although you can stash any stock or mutual fund in a Coverdell account, many 529s have high expenses and substandard investment options. Thus, it pays to shop carefully and to look beyond your home state's plan if it's not up to snuff. My colleague Sue Stevens has also written a terrific overview of the various ways to save for college.

Match Your Investments to Your Time Horizon
Finally, if you're planning to invest all or part of your bonus, pay attention to your time horizon for that money. If you're 30 and socking away money for retirement, aggressively positioned stock funds may be just the ticket. But if you plan to tap the money within a shorter time frame--to pay for college or buy a car, for example--you'll want to focus on conservative investments that jibe with your time horizon. In a couple of previous columns, I identified my favorite funds for short- and intermediate-term goals.

A version of this article appeared Jan. 4, 2005.