How to get the most out of a bonus

If you receive a bonus on top of your annual pay it should be a welcome additional boost to your finances. However, to get the full benefits of it you should use and or hold the extra money in the most efficient way.

Ensure that HM Revenue & Customs (HMRC) doesn’t think you earn more than you do. It adds up everything you’ve earned over a specific period and extrapolates that for the rest of the tax year, so might assume that this is a pay rise rather than a bonus. If HMRC estimates that your income is higher than it is, it might change your tax code and charge you a higher tax rate.

“If this happens, you get a note about your new code, including an estimated annual income," explains Sarah Coles, senior personal finance analyst at Hargreaves Lansdown. "If you know it has been wrongly triggered by a bonus you can call HMRC to correct it.”

When deciding how to use your money, paying down expensive short-term debts other than mortgages should be a priority. As well as saving on interest payment, doing this also reduces your monthly expenditure.

“If you’re on top of these debts, your next priority is to build an emergency savings [fund in cash] worth three to six months’ worth of your essential expenditure while you’re working," says Coles. "Then look at whether you’re on track with your pension.”

If you have a mortgage, see how much you could over pay it by. Over payments reduce long-term debt, and if you pay the mortgage off faster you will pay less interest on it overall. Low interest rates have meant that until recently it has probably been more profitable to invest surplus cash in assets such as equities over the long term rather than overpay mortgages. But if you have surplus cash it could now be worth making over payments as there have already been two interest rate rises in the past few months and there could be more. But before making over payments, check to see if there are penalties for doing this and only over pay as much as you can without being penalised.

But also weigh up the benefits of overpaying your mortgage against making extra payments into your pension. “If you have large or expensive debt you should prioritise paying some of this down before committing money to a pension,” says Louise Rycroft, financial planner at Timothy James & Partners. “However, if your only debt is your mortgage which is at a comfortable level and you have fixed it at a low rate of interest, making a pension contribution could be a very attractive option if you pay higher or additional rate income tax on your earnings. This is particularly the case if you are enjoying a period of high earnings which may not continue indefinitely. Pension contributions take advantage of the high tax relief available while you are a higher-rate taxpayer.”

Boost your pension

If you don't have short-term debt or expensive mortgage payments, or a short-term need for the bonus money, one of the best ways to get the most out of it is to put it into your pension – in addition to your regular monthly contributions. If your employer is willing to pay the bonus directly into your pension this means that you do not pay income tax or National Insurance (NI) on it. And it may keep you in a lower income tax bracket.

This is particularly effective if your bonus, when added to other income, takes your total income for the year over £100,000 as the pension contribution could effectively secure tax relief of up to 60 per cent. When you earn over £100,000 your Personal Allowance for income tax, which is £12,570 for the 2021/22 tax year, is reduced by £1 for every £2 of income over the £100,000 threshold. So if you earn £125,140 or more you completely lose your Personal Allowance. And rather than just £25,140 of your annual income being subject to 40 per cent tax, a further £12,570 of your earnings are taxed at this level.

“This means that the earnings of £25,140 over £100,000 are subject to total tax of £15,084, so 60 per cent,” explains Rycroft. “But making a pension contribution effectively reduces the amount of income which is subject to income tax. This reinstates your income tax-free Personal Allowance and enables you to receive 40 per cent tax relief on the pension contribution. So, for example, if you make a personal pension contribution of £25,140, this costs you £20,112 as 20 per cent tax relief – £5,028 – is added by the government straight into the pension. You can reclaim a further 20 per cent tax relief – £5,028 via your tax return. As this contribution effectively reduces your taxable income to £100,000, your Personal Allowance is reinstated and, as £12,570 of your income is not taxed, it saves a further £5,028. This means you get total tax relief of £15,084 – 60 per cent – based on a contribution of £25,140.”

If your employer makes a contribution directly into your pension it doesn’t usually pay employer NI at 13.8 per cent on the bonus. Rycroft says that you may be able to get your employer to pay some or all of its effective NI saving into your pension, increasing the value of your bonus.

A pension contribution via salary sacrifice could also allow you to retain some or all of the child benefit your family receives. If a bonus takes the income of a parent over £50,000 they have to pay back 1 per cent of the family’s Child Benefit for every £100 they earn over £50,000. If they earn £60,000 or more they have to repay it all.

A pension contribution via salary sacrifice “reduces your overall total pay [and can] keep you on the right side of the child benefit limit,” explains Coles.

When a pension contribution may not be best

If you are applying for a mortgage a bonus payment could help you get a larger loan. However, this would not be possible if you put it into a pension via salary sacrifice. “Not all lenders [consider a bonus] but some will and, if you salary sacrifice it [into a pension], you can’t include it in a mortgage calculation,” says Coles.

There are limits on the amounts you can pay into pensions. You can usually pay either up to £40,000 or the amount of your relevant earnings per tax year into a pension. And you can carry forward unused pensions allowances from the previous three tax years, although you cannot put more into pensions in a given tax year than your relevant earnings unless your employer is making the contribution.

However, if your threshold income is above £200,000 and adjusted income is above £240,000, your annual allowance is reduced by £1 for every £2 of adjusted income above this level. The taper stops at adjusted incomes of £312,000, so if you earn this amount or more you can only put up to £4,000 a year into pensions without incurring a tax charge – unless you have unused allowances from previous tax years.

George Martineau, chartered financial planner at James Hambro & Partners, says that an option could be to defer a bonus or split it across tax years if the number is substantial and unlikely to reoccur.

Also ensure that you do not breach or risk breaching in future the pensions lifetime allowance limit by making extra contributions into your pension. This has been frozen at £1,073,100 until April 2026.