Maximizing Your Bonus and Variable Income: Focusing first on achieving your savings objectives can free you to spend the remainder of your bonus or other variable income without remorse or concern.
Even for high-income individuals, variable cash flow can present some unique financial planning challenges. Managing money in the context of an asymmetrical distribution of pay is a learned skill, so more money can indeed lead to more issues.
Don’t get trapped wondering how to organise your income or use your money most effectively. Here is what you need to know in order to maximise your bonus or other lump-sum payments.
Maximizing Your Bonus and Variable Income: How to manage cash flow in light of your bonus and variable earnings
People receive variable income or lump-sum payments from a variety of sources. Some may be unpredictable in total quantity but predictable in timing. This could include bonuses, commissions, equity grants, business distributions, freelance income, or tax refunds.
Other sources of “variable income” may be more predictable in total, but their timing is entirely unpredictable. Consider inheritances, lottery winnings (though uncommon, they do occur!) and the net proceeds from significant, planned sales of assets such as a home.
Assuming you do not have urgent or emergency financial requirements when deciding how to use lump-sum payments, prioritise your savings goals. This strategy allows you to use the remainder of your variable-income funds without remorse or concern.
Here are the steps:
- Know how much you must save annually. Our firm advises allocating at least 25 per cent of gross income to long-term savings and investments. This includes contributions to retirement plans, IRAs, brokerage accounts, and health savings accounts.
- When possible, place the savings rate above all else. If you have pressing financial concerns or issues to resolve, this may not be feasible. In general, however, you should save whenever possible if you receive a large lump-sum bonus or commission payment to reach your savings rate objective earlier in the year.
- Once you reach your savings rate goal, you can spend any additional income or lump sums on what you want and what is most essential to you. This may involve financing other objectives, such as a family member’s college education or international travel with your significant other.
- By saving first, a budget for your expenses is automatically created. It is a natural method for limiting lifestyle inflation, which can be difficult to control with fortitude alone.
Two approaches to administering bonus funds or other variable sources of income
Methods for managing cash flow typically lie along a spectrum. Keeping close control over your cash flow can, from a mathematical standpoint, increase the likelihood of your overall financial plan’s success. This is due to the fact that it implies spending less and saving and investing more. The disadvantage is that it can be restrictive in the near term.
On the other hand, a more unstructured approach allows for “winging it.” This can reduce present-day stress by preventing the perception that you are perpetually nickel-and-diming yourself. It can also enable greater flexibility on a daily basis. But it is possible that your savings rate is not as high as it could be. This, in turn, could delay larger objectives and long-term plans. It could even compromise your ability to contact them.
People typically utilise systems at one extreme or the other. Here is an illustration of how this might work with actual figures. Suppose a couple earns approximately $500,000 in total compensation from a variety of income sources:
Consistent, predictable compensation totalling $300,000
A combination of bonus payments and grants of RSUs, or restricted stock units (which they sell upon vesting to generate a net financial profit), amounting to approximately $200,000 annually.
Assume that this couple adheres to the maxim “keep tight control of cash flow” which emphasises saving as much as possible. All of their financial planning could be founded on their $300,000 annual salary. They might establish a target savings rate of 25% and allocate $75,000 to long-term investments. They would then use the remaining $225,000 as their annual budget, less taxes and benefits. This would include their mortgage payment as well as other fixed expenses. It would also include any discretionary expenditures.
Any surplus funds from their variable income are placed directly into savings or investments. They might add to their long-term investments or fund additional savings objectives.
The advantage of this strategy is its aggressive savings plan. That is fantastic for accelerating progress towards objectives such as financial independence. The disadvantage is that you do not plan based on your actual income. You may unwittingly and artificially restrict your present and future possibilities. It also introduces a great deal of manual decision-making every time you receive bonus money or lump quantities. This can leave you susceptible to making errors or underfunding certain objectives or priorities.
Now let’s examine what occurs at the opposite extreme of the spectrum. This couple would earn the same amount of money, but would prioritise their spending requirements. They would presume their $300,000 base salary (less taxes and benefits) was their annual budget. Throughout the year, they would rely on their variable income to save, invest, and fund other objectives and short- or long-term needs.
This may succeed, but they must recognise the inherent risk involved. They invest their long-term savings less strategically. If a bonus falls short of expectations, their savings will likely take a blow, as their anticipated income has already been spent on your fixed expenses.
As with most matters, we believe a middle-ground approach is optimal. Good cash-flow management often results from making conservative income assumptions. It also avoids relying solely on an unpredictable bonus to meet savings objectives. You can also create a plan based on reasonable expectations of your total gross income, rather than pretending a bonus or other variable income will never materialise.
Two critical errors to avoid when handling lump funds
The source of variable income should not inherently alter your financial outlook or financial plans. In actuality, however, managing this type of cash flow involves a psychological component. People tend to regard money differently depending on its origin.
If humans were fully rational, we would never behave in this manner. $1 is worth $1 regardless of where it originated from: your paycheck, a bonus, an inheritance, or the sale of the property. However, despite its illogic, many of us engage in mental accounting by increasing or decreasing the value of a dollar based on how we came to hold it.
Avoid treating bonus funds and other lump quantities as “free and clear” Regardless of how you obtained this money, you must still engage in responsible financial planning. Instead of using the entire lump sum for discretionary expenditure, you could allocate it to the following purposes:
- Investing fifty per cent of the sum received.
- Allocating 30% to debt repayment.
- Utilising an additional 10% to finance a short-term objective.
- The remaining 10% can be spent on whatever you desire.
Keep in mind that the nature of your expenditure also matters. There is a significant distinction between spending a substantial amount of money once and making a financial decision that places a substantial, ongoing, fixed cost into your budget.
You don’t want to lock in a large, difficult-to-remove expense in your cash flow based on a particularly profitable quarter or year of revenue. You shouldn’t, for instance, take on a mortgage that would be unaffordable with your base salary alone and then rely on aggressive bonuses to make up the difference.
We wish to avoid basing our future plans on exceedingly optimistic numbers that may or may not hold true. That does not mean you should automatically presume the worst. Excellent financial planning searches out reasonable and realistic estimates to use based on what’s likely and then adds layers of padding or buffer space to keep your finances safe and thriving over time.