Your Bonus Arrived! (Part 1): How to Handle Uneven Cash Flow

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Bonuses. They’re the best, no?

A nice infusion of cash that comes in and opens up so many opportunities.

It’s bonus season for many of my clients, with bonuses being paid out in April, June, and/or August. So we’re working through what to do with the cash.

Let’s have a go at a quick two-part series about two aspects of bonuses:

• Part 1 (this post): A common issue people run into is how to manage the “cash flow” aspects of receiving a large bonus. In this post, we’ll look at a couple of different ways to deal with the issue of having uneven cash flow, illustrated with specific examples.

• Part 2: In Part 2, we’ll go into more detail about different ideas of what to do with the money.

First, what’s “cash flow” and what makes it “uneven”?

When I say cash flow, I’m referring to how cash flows into and out of your bank account.

As a simple example, if you have $10,000 coming into your bank account from wages each month, and you spend or save that same $10,000 each month, then your cash flow is even and you don’t need to worry about this much.

On the other hand, if the cash coming into your bank accounts goes up and down from month to month due to variable income and/or periodic bonuses, and your spending is variable as well, then your cash flow is uneven.

For example, if your expenses are $10,000/month, but your normal salary is $8,000/month, you have a $2,000 monthly deficit. But maybe that’s fine if you also receive two $30,000 bonuses each year.

Dealing with this is fairly common, especially for people who get big bonuses relative to their overall income. If those bonuses are relatively stable and predictable, then there’s a tendency to depend on them and build the expected income into one’s budget.

For example, perhaps you purchased a home with a mortgage payment that’s higher than you can cover on a month-to-month basis. But you got comfortable with it knowing your large bonuses would cover your costs. If your bonuses are relatively stable and predictable, and you have a healthy cash position (emergency fund), this can be a very reasonable thing to do.

So coming back to our topic, the question is … how do we deal with that uneven cash flow?

Two main methods

In working with my clients, we tend to take one of two approaches to this issue:

1. Allocate any extra cash to savings or other goals only when the income arrives.

2. Allocate any extra cash to savings or other goals on a prorated basis before (or after) the income arrives.

Let’s unpack those, starting with an example.

A hypothetical financial services employee

Let’s look at an example of a financial services employee who has a very healthy annual income from salary and bonuses of $535,000. That income is split up into $240,000 from regular salary ($20K per month), $45,000 from a performance bonus in April, and $250,000 from a profit-sharing bonus in August.

For ease of reference, let’s call this person, oh I don’t know, Lucy.

(By the way, the principles in this blog post can be applied at any salary/bonus level. So whether $535,000 is waaaaaaaay above your income level, about the same, or too low, you can benefit from reading on.)

Making some assumptions about Lucy’s spending, we’ll say she has a monthly deficit of $11,700 when incorporating only her salary. That is, her family is spending $11,700 more per month than she’s receiving.

But that’s not the end of the story, because she receives bonuses too. When incorporating her bonuses, there’s about $55,200 of “extra cash” that can be allocated (saved or spent).

Here’s a screenshot of a tool I use with clients to map this out:

A few notes on how to read this:

• The “Normal Monthly Salary” section shows numbers on a monthly basis. The top part shows the money coming in (along with deductions from paychecks). The middle part shows Lucy’s average monthly spending in various categories. The bottom part shows any savings done on a monthly basis. The bottom two rows show whether there’s a deficit or surplus. In this case, Lucy has a monthly deficit of $11,700, leading to an annual deficit of $140,400 (when only looking at her salary).

• The “Performance Bonus (April)” section shows numbers on an annual basis, representing a bonus that is received in April. After paying taxes, the income is used to fund the annual deficit from the left section, if any. In Lucy’s case, the entire bonus is put toward that annual deficit.

• The “SCP/Profit-Sharing (August)” section also shows numbers on an annual basis, representing a bonus that is received in August. After paying taxes, the income is first used to fund the remaining annual deficit from the middle section, if any. Then any extra income can be divvied up between goals (extra travel, home improvement, etc.) and savings (brokerage, Roth IRA, education, etc.). In Lucy’s case, there’s $55,200 left over to allocate to these goals/savings.

Also, I should note that a key to making either method work is having a decent idea of what numbers to plug into the MONEY IN and MONEY OUT sections of the “Normal Monthly Salary” section.

• MONEY IN: You should be able to get these numbers from your paychecks.

• MONEY OUT: This part is tougher, but it really helps to have a general idea of how much you are paying in debt payments, how much you’re giving to charity or others, how much you’re paying for housing costs & insurance premiums, and how much you’re spending on everything else. Coming up with these numbers is easier said than done, and is something I help my clients figure out.

So now let’s look at two ways that Lucy can allocate that extra $55,200 (from the bottom right of the screenshot).

Method 1: Allocating only when the income arrives

With this approach, you would wait until you receive your bonus(es), and then do two things:

1. First, put enough aside to fund the deficit from your salary and any other bonuses, if any, for the next 12 months.

2. Then decide how to spend or save the rest, if any.

Here’s how that might look for Lucy:

Notice that everything in the first two sections is the same. Then in the last (right-most) section, things start to get interesting.

First, Lucy puts $110,600 aside to fund her spending deficit for the next 12 months. She can put it in a savings account to be spent over the upcoming year.

Next, the fun part. What to do with the leftover $55,200? Oh, the possibilities.

Lucy decides to allocate $15K to a home improvement project (let’s finally get that bathroom spruced up!), $5K as a donation to a charity she likes, $14K to Backdoor Roth IRA contributions for her and her spouse, $10K to education savings for her children, and the rest, $11,200, to savings in a brokerage account.

This part is certainly more art than science. Lucy decides on a comfortable balance of present consumption, future retirement savings, college savings, and giving to others. I go into more detail about how to approach this in Part 2.

Now let’s look at the second method.

Method 2: Allocating on a prorated basis before (or after) the income arrives

With this approach, you would:

1. Take your projected annual savings amounts and allocate them monthly.

2. When you receive a bonus, put enough aside to fund the deficit from your salary and any other bonuses, if any, for the next 12 months.

3. Then you can put any additional cash, if any, toward spending and/or additional savings.

Here’s how that might look for Lucy:

With this method, Lucy decides to allocate on a monthly basis to her brokerage account ($933), their Traditional IRAs (for Backdoor Roth IRA conversions later) ($1,167), and their education savings ($833). She’s making an assumption that her future bonuses will cover these monthly contributions (or she has the money set aside from previous bonuses).

Then, when her August bonus is paid, she finds that there is $20,000 left over. She decides that she’d like to put $15K toward that home improvement project and $5K as a charitable gift.

Which method is best?

Well, that’s up to you. Either method can work. And both effectively end up in the same place.

Personally, method #1 resonates with me more. But they both have merits.

Here’s what I think are the main advantages of each method:

• Method 1 (Allocating only when the income arrives)

  • This method ensures that you don’t overcommit. By waiting until you receive the income, you know exactly how much you have to allocate to goals & savings.

  • There’s something kind of fun about deciding how to allocate a big chunk of money.

• Method 2 (Allocating on a prorated basis before (or after) the income arrives)

  • This method encourages you to prioritize the savings component over the goals (spending) component. This is a good thing! You decide ahead of time how much you’ll save and allocate it monthly. Then when the bonus comes you decide what to do with any extra cash above and beyond what you’ve been saving.

Method 1.5?

Of course, you don’t have to go all in on method 1 or method 2. There is an in-between place if you’d prefer.

For example, perhaps you like the idea of contributing monthly to your kids’ education funds, to make it part of your monthly budget. That’s method 2. But then for everything else you’d rather wait until the bonus comes, which is method 1.

So you can mix and match to find the right solution for you.

Let’s look at one last example. Let’s call this person Rob. Rob makes $189,000 per year, which is made up of a $144K salary ($12K per month), a performance bonus of $25K in April, and a profit-sharing bonus of $20K in June. He’s decided to take more of a method 1.5 approach.

Here’s what it might look like for Rob:

Rob has decided to contribute $300 per month to education savings, as he wants to prioritize that type of saving. Then he waits for both bonuses to hit before allocating the extra money.

When the April bonus is paid, he first funds his annual spending deficit ($15,600), then he has $1,000 left over. He decides to allocate that to his brokerage account.

When the June bonus is paid, Rob decides to take his family on a special weekend vacation ($2K). He then tops off the cash position in his bank account so that he’s better prepared for emergencies ($4K), and puts the rest ($7,300) into his brokerage account.

Closing thoughts

Getting a big bonus is awesome, but it also introduces certain complexities that need to be navigated. My hope is that thinking about your cash flow and bonuses in these ways will be helpful to you.

If you’d like some help looking at your specific situation, don’t hesitate to get in touch with us.