How to Make Your Bonus (and Raise) Pay off Big Time

By Carla Fried

Let’s face it, snagging a bonus or solid raise isn’t exactly easy these days. That makes it all the more important to make the most of any extra pay that comes your way. Don’t worry, I’m not about to suggest you save every penny. We’ll get to that sort of unimpeachable advice in a sec. But I’d put in a pitch for making sure you spend a portion on something that makes you smile. Maybe that’s paying off your credit card. But maybe it’s a long weekend getaway. Both have value. In our overworked and overstressed world where it’s hard not to worry, spending a little on checking out can be the secret to avoiding burn out. And that’s what enables you to excel at work…and earn the next bonus or raise. You decide how much feels right. Maybe you siphon off 75% or so of any windfall for solid financial planning, and give yourself the room to splurge with the other 25%.

Okay, now onto the best financial moves for any extra income:

• Pay off high rate credit card debt. ‘Nuff said. You know the drill here.

• Contribute more to your 401(k). The minute you hear the word “raise” contact HR or your plan administrator pronto and increase your contribution rate. If you do this before the first raise ever hits your paycheck you’re not going to “miss” having that money to spend. This is especially profitable if you have yet to max out on your company’s maximum matching contribution. By increasing your deferral rate you’ll be eligible for a higher match. You just got a bonus on your bonus!

• Fund a Roth IRA. Individuals with income below $107,000 and couples filing a joint tax return with modified adjusted gross income below $169,000 can contribute $5,000 per person this year into a Roth IRA. If you’re at least 50, the max is $6,000. If your MAGI is between $107,000-$110,000 ($169,000-$179,000 for couples) you can make a reduced direct contribution into a Roth IRA for 2011. If your income is above that upper limit, you can still finagle your way into a Roth by first contributing to a Traditional IRA and then converting that into a Roth. The big advantage of a Roth IRA is the prospect of having 100% tax free income in retirement. Remember, all withdrawals from a Traditional IRA will be taxed as ordinary income. In effect, with a Roth you pay your tax today, rather than in retirement. Unless you anticipate being in a low tax bracket come retirement, the Roth can be a better deal. Moreover, if you already have money in Traditional IRAs, adding a Roth IRA to your retirement mix gives you some tax diversification: you have both types of accounts that in retirement you can tap strategically based on your needs.

• Pay Down Your Mortgage. This is for the 50+ crowd. If you intend to live in your current home through retirement, using some extra cash flow today to get the mortgage paid off before you stop working can be both financially smart and psychologically calming. Or if you’re been hankering to refinance at today’s seriously low rates, but worry you won’t qualify for a loan given today’s higher equity requirements (typically 20%) consider a cash-in refinance. That’s when you bring some cash to the refinance so you can buy your way into having at least 20% equity. With bank savings rates at 1% or less, using extra cash to reduce your mortgage costs can be a smart move. Just make sure that when you refinance you don’t extend your original loan term. So for example, if you’re 10 years into a 30-year loan, take out a new 20-year mortgage. That way you don’t end up paying more interest over the total length of your payback of the two loans.