Windfall: Student loans - tax worries

[kerriohs]

Hello everyone :) Beginner Mustachian here.

I am lucky enough to be receiving a $10k windfall due to company acquisition. Though not a life changing amount, it's enough to pay off almost all of my remaining student loans (balance: $9.9k, average interest rate of 5.8%).

The $10k amount will be subject to payroll taxes as normal (I believe it is paid as a bonus), so I will be getting less than the gross number.

Like any good Mustachian, I would like to funnel these funds DIRECTLY to my student loan debt. But I've never received a windfall of this size before and don't quite know what to expect. Will this windfall have any tax implications after the normal withholding? I make 65k gross salary now, single, and do not expect that 10k will raise me up in the tax bracket. Google keeps telling me that I would be better off investing some of this windfall in a 401k, but I don't think those blanket rules apply to my situation.

I've been googling "what to do" when you get windfalls and I just wanted to be sure that, if I used all the money to pay off my loans, I wouldn't be slapped with a nasty bill in January when I file my taxes.

I'm a beginner Mustachian, only been reading the blog a few weeks, and I am new here on the forums. Thanks in advance for any help

[Proud Foot]

If it is paid through your payroll as a bonus then you should have Federal and State taxes withheld. This should cover any taxes on this windfall and should not leave you with a bill in January. As far as what to do with the net you receive, what are the balances and rates on your student loans? You stated an average interest rate making me think that you have multiple student loans.  Also how long would it take you to pay off these loans without this windfall? 

[catccc]

Bonus withholding rates are sometimes higher than your regular withholding rates, but at the end of the day (or the tax year) it's just like more of your regular ol' income.  I don't think you will be underwithheld, so I would just take the net pay from the bonus, pay down your student loans, and pat yourself on the back.  Good luck!

[johnny847]

catccc said this already, but I just want to drill this point home. Bonuses ARE NOT taxed at a higher rate. Sometimes your employer decides to withhold tax at a higher rate, but when you go to file your taxes, it all gets corrected.

If you want further proof of this, go find an old W-2. If bonuses were taxed at some special rate, like some people think they are, then they'd have to be designated in a separate box marked "bonuses" or something of the sort. But such a box doesn't exist. Bonuses are taxed the same way as any other wage income.

[Jack]

Google keeps telling me that I would be better off investing some of this windfall in a 401k, but I don't think those blanket rules apply to my situation.

You would, and they do (probably). In most cases, student loan debt has a lower interest rate (maybe 4%, on average) than the ~7% you can expect from the market in the long run (and that's before accounting for the tax benefits of either the 401k contribution or of making interest payments on the student loans). That means choosing to fund your 401k before paying off the loans makes you come out ahead by a couple of percent.

Of course, YMMV -- for example, if you would be paying off your loans soon according to the normal schedule anyway and you think Brexit might cause a market correction over the same time frame, then "average returns over the long run" could be a risky assumption.

The question you have to ask yourself is whether you want to be mathematically-optimal in your money management or whether you're debt-averse and want the psychological benefit of knowing you don't owe.

[ShoulderThingThatGoesUp]

Google keeps telling me that I would be better off investing some of this windfall in a 401k, but I don't think those blanket rules apply to my situation.

You would, and they do (probably). In most cases, student loan debt has a lower interest rate (maybe 4%, on average) than the ~7% you can expect from the market in the long run (and that's before accounting for the tax benefits of either the 401k contribution or of making interest payments on the student loans). That means choosing to fund your 401k before paying off the loans makes you come out ahead by a couple of percent.

Of course, YMMV -- for example, if you would be paying off your loans soon according to the normal schedule anyway and you think Brexit might cause a market correction over the same time frame, then "average returns over the long run" could be a risky assumption.

The question you have to ask yourself is whether you want to be mathematically-optimal in your money management or whether you're debt-averse and want the psychological benefit of knowing you don't owe.

OP's student loans are at 5.8% so in my opinion they should be crushed, destroyed, and rendered inoperable with any spare cash.

(OP, you did say average, so make sure to pay off the highest-interest ones first.)

[nereo]

.... Google keeps telling me that I would be better off investing some of this windfall in a 401k, but I don't think those blanket rules apply to my situation.

OP's student loans are at 5.8% so in my opinion they should be crushed, destroyed, and rendered inoperable with any spare cash.

The big question here is whether you get a company match for contributing to your 401(k).  If you do, then I'd say absolutely contribute enough to get the company match.  It is in a very real way money you are otherwise leaving on the table.  So if your company will match contributions 50% up to $4k, then contribute $4k!

Beyond that, I agree with ShoulderThing... kill the student loans.  Kill them now. Then do a happy dance.

[kerriohs]

Thanks all for the replies. Weight off my shoulders regarding the taxes!

Student loan balance and rates of loans are as follows:
interest rate   balance
5.00%   $1,455.35
5.35%   $3,874.62
6.55%   $3,143.07
6.55%   $1,474.20
I was making standard payments with no idea really of how long it would take me, because my raise is very recent and I was not willing to contribute much more before it. But as mentioned, interest rates are pretty high so I would indeed like to crush them now that I have that power.

Regarding the 401k: previously we had no 401k match but the new company WILL match once we switch to their plan (may take a month or two before it comes in effect) -- 50% up to 6% of the salary, so 50% of $3900. I have already been contributing this year into our old plan so I am unsure if that will be matched (I assume not, but can ask when we are actually enrolled in the new plan, for now I have no idea)

It looks like my plan will be to hold back $4k for the 401k for now, and everything else goes to the loans (highest interest first, of course).

More comments welcome if you have them, but for now thanks very much to everyone for the help. :)

[nereo]

Sounds like you've got it figured out.  I'd go ahead and kill both of the 6.55% loans right now, and probably the 5.35% loan as well, leaving you with just over $1k to funnel into your 401(k) once your company's plan gets settled to make sure you get the full match for 2016.  Then use your improved cash flow to kill that last loan quickly while funding an IRA (you will fund an IRA, right?  good!)

[SwordGuy]

catccc said this already, but I just want to drill this point home. Bonuses ARE NOT taxed at a higher rate. Sometimes your employer decides to withhold tax at a higher rate, but when you go to file your taxes, it all gets corrected.

If you want further proof of this, go find an old W-2. If bonuses were taxed at some special rate, like some people think they are, then they'd have to be designated in a separate box marked "bonuses" or something of the sort. But such a box doesn't exist. Bonuses are taxed the same way as any other wage income.

This is absolutely correct.

The extra money is withheld because the payroll systems are poorly designed or written.  It is perfectly possible to create a payroll system that will withhold the correct amount instead of over-withholding.    It's also possible to do this manually.

(I know because I've done just that.   It's not even that hard...)

[slowsynapse]

catccc said this already, but I just want to drill this point home. Bonuses ARE NOT taxed at a higher rate. Sometimes your employer decides to withhold tax at a higher rate, but when you go to file your taxes, it all gets corrected.

If you want further proof of this, go find an old W-2. If bonuses were taxed at some special rate, like some people think they are, then they'd have to be designated in a separate box marked "bonuses" or something of the sort. But such a box doesn't exist. Bonuses are taxed the same way as any other wage income.

This is absolutely correct.

The extra money is withheld because the payroll systems are poorly designed or written.  It is perfectly possible to create a payroll system that will withhold the correct amount instead of over-withholding.    It's also possible to do this manually.

(I know because I've done just that.   It's not even that hard...)

You are spot on.  The reason that the rate of withholding is often higher on a bonus check is that the payroll department leaves your withholding table at your current pay frequency and then cuts you a higher dollar check.  So the payroll program thinks you are making $10,000 semi-monthly, for example, and then withholds at a very high rate due to that.  That is not truly a correct way to withhold, but a lot of payroll systems/services make it really hard to change.  The more correct way to withhold is the 25% method from pub 15, circular E.  Either way, new windfall money is awesome.