Extra Income? What to do before it’s gone.

AAs spring’s arrival gets closer, you may also be anticipating the arrival of a large inflow of “extra”
income.  This may be in the form of an income tax refund, pay raise, annual bonus, stock grant or restricted stock vesting.   Before this extra income actually hits your bank account, take some time to consider the best use for these additional assets.  Otherwise, it is too easy for the additional dollars to erode away while they sit in your checking account commingled with your regular income.

Tax Refunds:

In the case of a tax refund, let’s first examine the circumstances surrounding a big refund.  If this is a rare occurrence, then you need to consider the best use for your one-time windfall.  This might include a contribution to a Roth IRA, rebuilding your emergency savings or setting aside for an upcoming car purchase.

If a sizeable refund is an annual event for you, consider the following.  By withholding more tax than you need on all your paychecks throughout the year, not only are you forfeiting use of that money, but typically you have to wait until April before you finally get that overage returned to you.  Now consider what you earned on those withholdings during the year?  Nothing!  Not only did you earn nothing, but the U.S. Treasury got to have use of your money without paying you anything to use it.

Some consumers talk about big tax refunds as a “forced” savings for themselves.  They say it is a good way to have some extra income show up every year.  This may seem like a logical approach, but here is an alternative to consider.  Use the following 2-step process to initiate the change:

  1. Change your federal and state tax withholding amounts to reduce the amount being withheld. Give yourself some wiggle room, so that you don’t end up owing taxes at the end of the year.  Your tax preparer can assist you in selecting the correct amount of withholdings.  Submit this W-4 to your employer for implementation.
  2. At the same time, set up an automatic deposit directly from your paycheck to a savings account or other “non-checking” account. Most paycheck processors allow for multiple destinations when specifying direct deposits.  This automatic deposit should equal the difference between your old withholding and your revised withholding.  Now, keep your hands off this savings bucket and treat it the same way as your tax refund, so that it is available when you need it.

Pay Raise:

The method mentioned above of directing a set, monthly amount to a different, less accessible savings account, is also a great way to keep from ramping up your lifestyle each time you get a pay raise.  When the raise is set to hit your paycheck, increase your savings to the alternate location by the same amount as the raise.  You’ve been living on the lower amount already, why not be intentional about the increase and save it for what matters most.  These tactics help to keep increases such as refunds or pay increases from getting eroded away when these extras get comingled with the regular cash flow.

Bonuses:

Annual bonuses from your employer can be a real boost to your total income, even after the mandatory high tax withholding.  It is important however, to be careful not to lose sight of the meaning of “bonus”.  Bonuses should be viewed as extra, uncertain income that is above and beyond your salary.  It is easy for it to become an expectation, especially if you’ve received a bonus for a few years in a row.  The problem comes when you have adjusted your spending such that it becomes a necessary boost to your cash flow in order to make ends meet each year.  Your bonus should not, generally, be paying regular ongoing bills.  If you find that you are waiting impatiently for the bonus to arrive so you can pay off accumulated ongoing expenses, you may need to take a serious look at your current spending to find ways to rein in the totals to a more sustainable level.   The reasoning is simple, there may be years when the bonus doesn’t arrive, and you can’t have that event be the unraveling of your financial future.

Restricted Stock/Performance Stock:

Many corporations use a combination of cash bonuses and stock grants as a means of rewarding their best employees.  The stock grants, whether they are performance shares, non-qualified grants, or restricted stock units (RSUs), typically vest over a 3 or 5 year period of time.  This becomes a means for employers to incent employees to remain with the company, in order to meet the vesting requirements to receive these shares.

When the restrictions lapse, these shares immediately become vested and typically trigger a taxable event for employees, as in the case of Restricted Shares or Performance Shares.  Depending on what you have selected, vested shares may be used to pay the associated taxes, with the remaining shares either being sold immediately to cash or held as shares of the employer stock.    If the resulting shares are being held once vested, you may be accumulating shares in your employer stock, which needs to be considered in your comprehensive financial picture.  You and your financial advisor should devise a stock liquidation strategy for your shares, to ensure you are periodically liquidating shares, taking into account any blackout periods you may be subject to, as well as capital gains status, continued grants you are receiving, and overall diversification.  It is important, no matter what the employer stock is, that you remember the need to diversify this aspect of your compensation when appropriate.  Because you have your human capital (your ability to earn an income) tied up in this employer, as well as many of your insurance coverages, your health benefits, etc.,  it is important that you don’t become overly weighted in this same employer financial capital as well.

 

In all cases where you have a significant amount of money arrive at once, you need to have thought through the destination for that money prior to receiving it, so you are able to act swiftly and allow it to be put to its highest use.  It may be eliminating a credit balance, making a Roth IRA contribution, or building up your emergency reserves or investment portfolio.  Talk with your advisor about best-use strategies for deploying excess cash, as well as an ongoing strategy for reducing exposure to your employer stock because of restricted or other types of share grants.  Since spring is upon us, we should all be planting seeds for a successful financial future. Click here to schedule a free appointment with one of Clearview’s NAPFA Registered Financial Advisors to discuss your situation.