What to do with your year-end bonus.

CAROLERS RING OUT THEIR CHORUSES, THE smell of wood smoke hangs in the air and there's a Santa in every mall. And because you have been very, very good over the past year--at work, at least--you will definitely have yourself a merry little Christmas. Specifically, you've just earned a bonus.

What to do with it? Since this is the season of giving, your first temptation will undoubtedly be to give a little something to yourself or loved ones--perhaps that high-end CD player or a swanky shearling coat? Certainly, splurging a little isn't such a bad idea. "I think it's okay to spend some of your bonus money on yourself," says Oakland, Calif.-based financial planner Cheryl Broussard. "You must've done something good for your company to get it--you deserve a reward." Besides, she adds, "If you don't let yourself enjoy the money, you might not be inclined to keep working as hard to earn more of it."

Yet, that doesn't mean racing out and charging up a sleighful of grown-up toys. Though experts say it's acceptable to spend up to a third of your bonus on whimsy, you'll want to be especially smart about how you use the rest of your new funds. "A bonus is not a regular part of your income," says John Markese, president of the American Association of Individual Investors (AAII), a Chicago-based nonprofit education group. "This is a reward for your creativity, so you should be creative about what you do with it," he points out. Whether you find yourself with $500 extra dollars or more than $5,000, here are some prudent suggestions from the pros.

REMEMBER THAT THE TAX MAN COMETH 

Regardless of your plans for the new money, don't forget the impact of taxes on your cash. Although the new tax law mandates that rates this year and next year will be the same (the top rate: 39.6%), don't be lulled into thinking that the timing of your bonus--whether you take it in December or January--won't matter. It does. For one thing, if you take your bonus in January, you won't owe taxes on the money until the succeeding year--in this case, April of 1995. Then too, the new tax legislation lifts the $135,000 income cap on Social Security taxes. Thus, if the bonus pushes your salary over that amount, "take it now," advises James Velten, New York-based senior tax manager at the accounting firm of Coopers & Lybrand. "Once you have earned income above $135,000, you pay 1.45% on every dollar of additional income," he says.

BEFORE DECKING THE HALLS, GET YOUR FINANCIAL HOUSE IN ORDER

If you have any sort of credit card or revolving debt hanging over your head, a bonus gives you a great opportunity to wipe it out now. "When you pay off your credit cards, you earn an awesome return," declares Markese. "Most cards charge about 18% in annual interest. You can't make 18% risk-free anyplace else."

"If you carry just $1,000 in credit card debt, you spend about $180 in interest on it each year. That's real money," says Malcolm Makin, a financial planner from Westerly, R.I.

Another ho-hum, but critical, place for your bonus: Use the money to help set aside an emergency fund, typically three months' worth of living expenses. How much extra income you put toward this goal should depend on how much you've already got stashed away, explains Walnut Creek, Calif., financial planner Lynn Ballou. "Keep the money in a short-term bond fund or money-market mutual fund where it's not as easy to get to as it would be in a bank," she advises.

Finally, use the bonus to start investing for yourself, if you haven't already. Probably the best way to begin, suggests Markese, is through any of over 4,000 mutual funds (see "6 Great Mutual Funds," Oct. 1993). Through a fund you get into the stock market (historically, the stock market has outpaced practically every other type of investment) at lower risk than if you purchased shares in a single company. "Your extra money should be diversified and invested for the long term," he counsels. "Remember, you got a bonus this year, but you might not the next."

USE THE MONEY TO REACH A BIG GOAL THAT SEEMED DISTANT BEFORE

A sizable bonus--say $20,000 or more--can be used as a down payment on a new home. But as little as $2,000, or even less, can also help you achieve financial independence. For example, an IRA may no longer be tax-deductible for most people, but you can still contribute up to $2,000 annually toward your retirement through one. "You don't have to invest the whole $2,000," points out planner Broussard. "But whatever you contribute compounds tax-free until you withdraw the money. And because of the significant penalties you would likely incur if you withdrew the cash before age 59 1/2, an IRA helps discipline you to save for the future." Indeed, there are particularly compelling reasons to begin stashing more away for retirement from now on, Broussard notes. The new tax law reduces the percentages top-earning employees can contribute to 401(k), SEP and Keogh retirement plans. Since chief executives can no longer shelter as much of their salaries from taxes, this could cause some small companies to eliminate 401(k) plans altogether, Broussard notes. "This year more than ever it pays to start saving for retirement on your own," she emphasizes.

If you have kids and keep meaning to set aside money for their college education--but just haven't gotten around to it--your bonus could be the perfect place to start. By establishing a Uniform Gift to Minors Account, or UGMA, you can transfer the money into your child's name. You'll save on taxes, too, since the money will be taxed based on the child's income bracket (see an accountant or financial planner before setting up a UGMA).

THINK ABOUT USING THE BONUS MONEY IN A NOVEL WAY

If you've shied away from stocks in the past, believing they were too risky, now might be the time to get into them. One of the most painless ways to start is to buy high-quality blue-chip stocks directly through a dividend-reinvestment program sponsored by the company issuing the stocks. You don't need a lot of money. Shares in New York Stock Exchange-listed Exxon (800-252-1800) or Dial (800-453-2235) can be purchased for as little as $250 and $100, respectively. You'll save a bundle--as much as 6%--on commissions. Once you're a shareholder in a dividend-reinvestment program, you can often make additional investments for as little as $50, says Charles Carlson, editor of the investment newsletter Dow Theory Forecasts and author of Buying Stocks Without a Broker (McGraw-Hill, New York, $16.95).

Another investment you may have overlooked is owning shares overseas. Though European stocks have enjoyed a run-up this year, shares in developing markets such as the Far East and Latin America "have great promise," says Markese of the AAII. The best way to invest overseas is through a mutual fund such as T. Rowe Price New Asia (800-638-5660; up 29.34%, 8/31/92-8/31/93) or Scudder Latin America (800-225-2470; up 32.72%, 8/31/92-8/31/93). "A lot of these nations have controls on how to invest," he explains. "You can't get in unless it's through a fund."

INVEST IN SOMEONE CLOSE

The best way to spend the holidays is with people you care about, and the best part is giving gifts. This season, with your bonus income at hand, you'll likely be able to pay for at least some of your Christmas presents in cash. On the other hand, why not do something lasting for the one you love? Makin suggests that you sit down with your spouse or significant other and discuss how much you have to spend and what you can do with the money to enhance your relationship. Using your bonus to grow closer to your lover? It could be the happiest way of all to ring in the New Year.