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How to spend your bonus
By Jeff Salway
It's very tempting to treat a bonus as different to your regular income and think of it as unexpected, disposable money. But this is why it's worth taking a step back and thinking about how you spend it.
Where do you start?
If you have debts or have a financial hangover, then addressing these should be your top priority, advises Jo Roberts, director of Needanadviser.com. "A lot of people use bonus money to cover Christmas spending," she says.
Alternatively, you could pay off nagging debts. Whichever type of debt you have, you need to prioritise those with the highest interest rates. "Credit and store cards normally charge the most interest," says Roberts.
Smaller mortgage
If you have no personal debts, think about your mortgage. "If interest on your mortgage is calculated daily, invest the extra money. If it's an annual interest mortgage, find out when the interest is deducted from your mortgage, put the money in a savings account until that date, and then pay it off," suggests Roberts.
The benefits of overpaying your mortgage should not be underestimated. For example, if you pay £3,000 off a 25-year £70,000 repayment mortgage at 6.5% in the third year, you'll save £8,702 on the total owed, knocking 2.1 years off the repayment period.
Pension investment
A lump sum investment in a pension - through your employer, or in a personal pension or a self-invested personal pension (SIPP) - could give your retirement income a massive boost.
Ian Smith, director of Central Financial Planning, says the new, simplified pensions regime introduced in April 2006 means topping up your pension is easier than ever. "It has really boosted the options," he says.
Prior to the rule change you could only put a certain portion of your earnings into your pension (company or personal), but now you can now pay in 100% of earnings up to £225,000 - increasing to £235,000 in April. Anything over that will be taxed at 40%.
For example, if a 40-year-old basic-rate taxpayer put a bonus of £5,000 into a new personal pension without further contributions, assuming 7% growth (although this would vary with the type of funds selected within the pension), it would be worth £20,300 by the age of 60.
If you have a company pension, it's worth asking your employer to pay your bonus straight into your scheme - if your company matches your contributions, you would be increasing your bonus in an instant.
Since the introduction of the new rules, SIPPs have become even more popular, as they make it much easier to control your money. However, SIPPs are only suitable if you have at least £50,000 to invest.
Savings habit
A lump sum can also be a great way to kick-start a savings or investing habit. If you want to grow your cash reserves and build an emergency fund, the first option to consider is individual savings accounts, which are tax-free. At present, you can contribute £3,000 to a cash mini-ISA, but this will rise to £3,600 in April.
If you've already used up this year's allowance, there are plenty of savings accounts paying good rates.
If you're happy to put your money out of reach for at least five years and have a healthy cash reserve, consider investing in equities. For example, a cautious managed fund will limit the potential downside, although this also means you might not get as much growth as you would from riskier funds.
Remember too that many investment funds can be held within equity-based ISAs, meaning gains are tax-free. Each year you can invest up to £4,000 in a mini stocks-and-shares ISA. Alternatively, if you want to invest more than £4,000 you can go for a maxi-ISA, into which you can put £7,000 in equities, or £4,000 in equities and £3,000 in cash.
Think of the children
If your savings are looking healthy, you could use your bonus to help secure your children's future. All children born after September 2002 are entitled to a tax-free Child Trust Fund. If you invested £1,200 (the maximum annual contribution) each year into a savings-based CTF opened on 1 January this year with the initial £250 from the government, it would be worth at least £29,000 when the child turns 18. If you pay the same each year into a shares-based CTF, annual returns of 7% could produce returns in excess of more than £37,000 in 18 years. If your child is too old for the CTF there are still a host of other children's investments - however, they will not have the same tax advantages.
Big bonuses
If you're lucky enough to get a king-size bonus that dwarfs your salary the urge to splurge could be irresistible. But the same factors apply even where bonus payments are in the millions, according to. "We're all attracted to quality of life in the short term rather than the longer term," Richard Admiraal, director of London-based wealth management firm Route Group says.
Because many City professionals are looking to retire earlier than most of us, there's a big focus on ensuring their pensions are well-funded, as long as they stay within the lifetime investment limit, set initially at £1.5 million, but rising to £1.8 million in 2010/2011.
Admiraal cites property as another popular outlet for windfalls, whether it's a second home, buy-to-let or property syndicate.
As far as other investments are concerned, the emphasis for high-income earners in the top tax bracket is tax-efficiency. So, qualifying investments such as some alternative investment market (AIM) stocks, where tax relief may be available after two years, become relevant.
So, whether your bonus is £1,000 or £1 million, there are plenty of options open. They may not be the first thing that you want to do when you get your hands on your windfall, but you could reap the benefit of your restraint for years to come.
Make the most of your windfall
Pay off your debts: If you've got credit or store cards rapidly accruing interest, pay them off first.
Overpay your mortgage: You can take months or even years off your mortgage by paying in a lump sum.
Line your pension: If possible, ask your company to pay your bonus straight into your pension scheme - that way you won't have to pay tax on the money.
Save for the future: Use your individual savings account (ISA) allowance to build up tax-free savings or put some money away for the long term and let it grow in an equity fund.
Aim high: If you're a wealthy higher-rate taxpayer with sufficient savings, consider investments such as venture capital trusts or AIM funds to capitalise on generous tax relief.
Live a little: If the thought of using your whole bonus sensibly sounds too responsible or painful, you can always set a small amount aside to treat yourself.
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