Like other retirement accounts, your 401(k) grows on a tax-deferred basis. You can make elective deferrals of your salary or even your bonus into your 401(k) and avoid having to pay taxes until you make withdrawals. However, the Internal Revenue Service imposes contribution limits on 401(k)s and your bonus may cause you to exceed the limit. Taxes aside, in some instances, it pays to invest only a portion of your bonus in the account.
As of 2013, your basic annual pre-tax contribution to your 401(k) cannot exceed $17,500. If you are age 50 or older, you can make an additional contribution of up to $5,500 per year. Contribution limits are subject to annual cost-of-living adjustments. Depending on the size of your bonus, you may reach the annual contribution cap long before you reach the end of the fiscal year. If you inadvertently contribute too much to the account, then you may have to pay an excise tax on the excess contribution. You then pay tax on the money for a second time when you eventually withdraw it.
Your elective deferrals are automatically deducted from your paycheck. Typically, 401(k) contributions are fixed as a percentage of your paycheck. If you receive a bonus, the same fixed percentage would ordinarily be deducted from that check. Depending on the size of your company and the flexibility of the payroll department, you may or may not have the option to bump up your 401(k) contribution limit to cover your entire bonus.
Many employers make matching contributions to 401(k) accounts such as a match on the first 6 percent of your pay. If you earn $100,000 per year and with your first paycheck and bonus, you end up investing $17,500 into your 401(k), your employer's matching contribution would amount to $1,050. Neither you nor your employer could contribute to the account for the rest of the year because you hit the annual contribution limit with your first paycheck. If you invested the same sum of money into your account in equal increments over 24 paychecks, your employer could make 24 matching contributions of $250 while remaining under the matching contribution threshold. You would end up with $6,000 in employer contributions.
You can avoid taxes in the short term by investing your whole bonus in your 401(k), but the move could prove costly if you run short of cash. Many 401(k) plans include a provision for employee withdrawals in the event that an employee experiences a financial hardship. If you end up needing to make such a withdrawal, you have to pay income tax on the amount you withdraw. If you are under the age of 59 1/2, you also pay a 10 percent federal tax penalty. Therefore, consider your upcoming expenses before you commit your entire bonus to your 401(k).