Interactive Investor

Got a bonus or a raise? Here’s how to use the money wisely

As bonus season draws to a close, Craig Rickman offers some tips on how to make the most of any extra capital or monthly income.

3rd April 2024 11:23

by Craig Rickman from interactive investor

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Getting a decent pay rise or receiving a hefty bonus is never a bad thing. Who doesn’t love a bit of extra cash to play with?

But this also comes with some important decisions. Should you spend the money on things that are pleasurable or useful right now? Or tuck it away to boost your future financial security?

While you might naturally veer towards the former, delaying gratification can bring real benefits as I explain further down.

Still, there is no right or wrong answer when choosing what to do with a bonus or salary bump. The key is to carefully evaluate all your options before making any big financial decisions. This will provide peace of mind that you haven’t overlooked something more suitable.

Although not all workers will have received a noteworthy pay boost this year, most will see an uplift over the next 12 months thanks to the national insurance (NI) cuts announced at both the 2023 Autumn Statement and this year’s Spring Budget.

According to government calculations, the combination of these reductions will see the average employed worker save £900 a year in tax, while self-employed workers will save £650 on average.

These changes will indeed put some extra money in workers’ pockets, but the rising cost of living will absorb at least some of the increase to your pay packet or profits.

The news that inflation softened to 3.6% in February was positive, though prices are still rising far speedier than the Bank of England’s 2% target. This is predicted to change over the coming months. However, you may need the additional cash to make sure your financial position stays the same over the next 12 months.

But for those set for a sizeable boost to their monthly pay, perhaps due to a promotion, or who have pocketed a particularly generous bonus, let’s explore what the options are.

Supercharge your retirement pot

One largely inescapable drawback of receiving a bonus or raise is that you will pay some extra tax. It could even push you into a higher tax bracket. But one solution is to pay the money into a pension.

The Stanford Marshmallow Experiment offers a useful illustration of the benefits to this approach. For those unfamiliar with the study, it was conducted in 1972 and studied delayed gratification. Kids were offered the chance to eat one marshmallow immediately or get two if they waited just 15 minutes.

Of course, paying into your pension means you’ll have to wait far longer than a quarter of an hour to reap the benefit. Under current rules you can’t access pension savings until age 55 (rising to 57 in 2028). On the flip side, you will get far more than an extra marshmallow, especially if you pay higher rates of tax.

For instance, let’s say you’re a 40% taxpayer and receive a £5,000 annual bonus. The amount that will end up in your bank account will be £2,900 as you’ll pay £2,000 income tax and £100 (2%) in national insurance (NI).

But if your employer allows bonus exchange, where you swap some or all your bonus for a pension payment, the full £5,000 will escape both tax and NI – shaving £2,100 off your tax bill and giving your retirement savings a shot in the arm.

Even if you’re a basic-rate taxpayer, you will save £1,000 in income tax (20%) and £400 in NI (8% from 6 April).

If your employer doesn’t offer bonus exchange, you can still pay into a pension, such as a self-invested personal pension (SIPP), after the money hits your bank account. While there’s no NI saving, you could still get 40% tax relief, although you would need to reclaim half of this via your tax return.

It can also be a good idea to up your pension contributions if you receive a pay rise, no matter the size. Even small annual increases to account for inflation can deliver a significant boost to your eventual retirement pot.

One final point here. If your bonus or raise pushes into a certain earnings bracket, paying into a pension could also enable you to avoid harmful things like the child benefit charge, and help you to keep your personal tax allowance. In both instances the effective tax saving could be 60% or more.

Restart pension contributions

Research by data science firm Outra found that in the past 12 months the number of workers in their 30s who have paused pension contributions has increased by more than 5% - or 72,000.

For some, this course of action, while not ideal, is justified. Rent and mortgage costs have soared since the cost-of-living crisis emerged, as have fuel and food prices. Cutting back on long-term savings might be the only way to make ends meet.

But even if you haven’t received a pay rise, the NI cut, due to take effect in a few days’ time, could free up some extra cash to resume pension contributions.

This could make a big difference to your future. Research from Standard Life found that a 25-year-old who opts out for just three years could have £36,000 less in savings by the time they retire.

Invest but keep the money accessible

Tying up your bonus until old age may be off the table for some; you may prefer to enjoy the money before you pack up work. But if you have no immediate plans to spend it, then you should still consider putting the money to work.

Sticking your bonus into an individual savings account (ISA) won’t trim this year’s tax bill, but can help reduce future ones. You can save and invest up to £20,000 in ISAs every year, and any gains and income are tax free, meaning you get to keep more of the money you make.

Although the 2023-24 tax year ends in just a couple of days’ time, you still have time to fill up this year’s allowance if you act fast.

The flexibility of ISAs means you don’t have to commit lump sums. If you’ve received a decent pay rise, giving you extra disposable cash every month, a sensible strategy can be to drip-feed this money into your ISA.

And you don’t have to commit vast sums. A £150 a month contribution could accrue to more than £23,000 in 10 years’ time, assuming 5% annual growth net of charges - a tidy sum to do something with down the line.

Support a child’s future

From toppy house prices and high university fees to increasing pressure to save enough for retirement, young adults face a wave of financial challenges.

So, if your financial goals are already on track, using your bonus or pay rise to build a child’s nest egg can help ease the burden on them later on life.

If you’re looking to support them in the early stages of adulthood, such as buying a car or first home, a Junior ISA could do the trick. You can pay in up to £9,000 a year, any growth and income is tax free, and the savings will transfer into an adult ISA once they hit age 18.

Looking even further ahead, a Junior SIPP can give them a major head start on a child’s retirement savings. You can contribute a maximum of £2,880, and this is grossed up to £3,600 thanks to upfront tax relief in the form of a government top-up. To illustrate the potential benefits, this article by Faith Glasgow explains that with a bit of dedication, you could make your child a pension millionaire.

Clear debts

If you have borrowings, then it can be a good idea to reduce these – or even pay them off. Unsecured loans, such as credit and store cards, should take priority, as the interest rates charged can be exorbitant. According to Moneyfacts, the average purchase annual percentage rate (APR) on credit cards currently stands at an eye-watering 34.7%.

Reducing your mortgage could also be considered, but the situation isn’t quite so cut and dried. First, you need to watch out for any early repayment charges. and second, boosting your pension savings might be more shrewd. Alice Guy, ii’s head of pensions and savings, has written a great article to help you decide.

Beef up your emergency savings

Admittedly, this is not the most exciting of options, but having a sufficient rainy-day fund is central to any prudent financial plan - an amount equal to three-to-six months expenditure in an easy-access savings account should do the trick.

We all need a safety net in place to support us and our loved ones should something happen out of left field such as losing your job or the boiler packing up. With any luck, you’ll never need to dip into your emergency pot, but it will provide some much-treasured peace of mind.

And lastly…spend some

Good financial planning isn’t solely about saving for tomorrow. You need to enjoy today too. In fact, saving a bit and spending a bit of your bonus and/or pay rise can offer the best of both worlds.

Important information – SIPPs are aimed at people happy to make their own investment decisions. Investment value can go up or down and you could get back less than you invest. You can normally only access the money from age 55 (57 from 2028). We recommend seeking advice from a suitably qualified financial adviser before making any decisions. Pension and tax rules depend on your circumstances and may change in future.

Please remember, investment value can go up or down and you could get back less than you invest. If you’re in any doubt about the suitability of a stocks & shares ISA, you should seek independent financial advice. The tax treatment of this product depends on your individual circumstances and may change in future. If you are uncertain about the tax treatment of the product you should contact HMRC or seek independent tax advice.

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