Investing a bonus tax efficiently
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Introduction
When it comes to bonuses, a general guideline suggests allocating around 30% for spending and saving the remaining 70%. However, it’s understandable to indulge entirely in the first instance, fulfilling a long-desired purchase.
Regardless of your circumstances, it’s prudent to devise a plan to anticipate any potential tax implications. Whether you allocate 70% or adjust the proportion based on your needs, it’s also important to consider both short and long-term objectives.
Short-term goals could include expenses such as school or university fees, weddings, or other family obligations. Long-term goals typically revolve around retirement and estate planning, ensuring sufficient funds are set aside to sustain desired lifestyles for yourself and your family beyond your working years and after your passing.
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In general, prudent saving involves setting aside funds for short-term needs, whether that’s for unexpected expenses or for specific purposes like holidays, cars, or home improvements. Typically, this involves depositing money into easily accessible cash accounts or Cash ISAs.
While cash savings play a crucial role in our financial toolkit – financial advisors often advise having three to six months’ worth of emergency funds, if feasible – they may not be ideal for long-term objectives. One reason is that cash tends to lose its value to inflation over time.
Saving part of a bonus in easy-access formats may also have tax implications, if the interest you earn exceeds your annual savings allowance (£1,000 for basic rate taxpayers, £500 for higher rate taxpayers and zero for those paying the additional rate).
Please note St. James’s Place do not offer easy access cash accounts or Cash ISAs.
This is where investments play a crucial role. Investing entails allocating funds and allowing them to grow over time, benefiting from the compounding effect, where returns generate further returns. While investing involves assuming more risk, market fluctuations have the ability to balance out over the long term (five years or more).
It’s a good idea to utilise your annual allowances, investing some of your bonus into ISAs (up to £20,000 a year), or a pension (up to the lower of £60,000 or 100% of earnings, other than for those on very high incomes for whom their pension annual allowance may be tapered.
One downside to earning a bonus is that it might push you into a higher tax bracket.
Planning ahead is far preferable, allowing you to mitigate potential tax liabilities before they arise, thereby avoiding last-minute stress.
One strategy to minimise the impact is to allocate a portion of the bonus directly into your pension through salary sacrifice. This approach not only reduces National Insurance and income tax but also enhances your pension savings simultaneously.
It’s worth noting that if your bonus elevates your annual earnings beyond £100,000, you may be at risk of an effective 60% rate of tax on your income – read more about avoiding this tax trap.
Your employer may enable you to receive your bonus through avenues other than in cash. This might help mitigate tax, for example through salary sacrifice schemes, or by earning shares on which you may be able to defer any tax due, until their value is realised.
It’s just as important to take expert advice from a financial planner in these circumstances. In sacrificing earnings, you may for instance reduce your borrowing eligibility for a mortgage.
The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.
The levels and bases of taxation and reliefs from taxation can change at any time. The value of any tax relief generally depends on individual circumstances.
