A year-end bonus is a nice reward for your hard work — and a helpful infusion of cash, especially after holiday-related spending. But before you count on adding the full amount of your bonus to your bank account, it is important to note the impact of taxes.
Otherwise, “you might be in for a surprise when your paycheck arrives, and you ask yourself, ‘Wait a minute — why are bonuses taxed so high?'” said NerdWallet. Even though “bonuses are considered earned income just like your salary or other work wages, which means they’re subject to ordinary income tax rates,” when it comes to “how taxes are withheld on your paycheck when you receive the bonus, it’s a different story.”
How are bonuses taxed?
“Bonuses are considered wages and are taxed the same way as other wages on your tax return,” said Intuit TurboTax — but when it comes to withholding rules, “the IRS doesn’t consider them regular wages.” Instead, your bonus counts as supplemental wages, meaning not part of your regular wages, and “can be subject to different federal withholding rules than your regular wages.”
Withholding is effectively your employer’s way of prepaying the taxes you’ll owe to the IRS, so you don’t have to do so later. There are two different ways that your employer may withhold federal taxes on your bonus:
The percentage method: “When an employer taxes your bonus using the percentage method, it must identify the bonus as separate from your regular wages,” said Bankrate. The withholding rate for bonuses up to $1 million during the tax year is 22%, and it increases to 37% for any amount over $1 million.
The aggregate method: “With the aggregate method, the tax withholding on your bonus is calculated at your regular income tax rate,” said Bankrate. This method often means “your initial tax withholding is higher,” but it’s necessary if your employer does not separate out your bonus amount from your regular wages, lumping them together into a single paycheck.
Keep in mind that “in addition to federal withholding, you likely will need to have taxes withheld for Medicare and Social Security (also called FICA taxes), and your employer may withhold state taxes on the bonus as well,” said NerdWallet.
Are all types of bonuses subject to taxes?
While all forms of bonuses — performance, holiday, signing and profit-sharing — are subject to taxes, there are certain types of extra perks, such as fringe benefits, that may not be.
“If you receive fringe benefits — for example, tickets to an event or gift baskets — these may not always be considered taxable,” said Intuit TurboTax.
Still, while “things such as occasional tickets for events, holiday gifts, money for meals while working overtime, flowers, books and other intermittent low-value fringe benefits are generally considered nontaxable,” said NerdWallet, if your employer “forks over cash, offers you a gift card or hands over a high-value gift, things get murkier.” This is when consulting a tax expert can be a good move.
Is there any way to minimize the impact of taxes on your bonus?
Put simply, “you can’t avoid the tax on your bonus,” said Kiplinger. However, there are strategic tax moves you may want to consider making if, say, the addition of a bonus tips you over into a higher tax bracket.
In this situation, “you could consider deferring your bonus to the next tax year,” said Kiplinger, asking your employer if they would pay out your bonus in the next calendar year rather than in December. If that ship has already sailed, other ways you could reduce your taxable income include “tax deductions for donations to charity or contributions to your retirement savings account.”
And if your bonus seems shockingly small after taxes, take heart: “If too much is withheld for taxes during the year, you’ll get a tax refund after you file your tax return,” said U.S. News & World Report.