If you got cut a big fat bonus check last year, the extra cash was no doubt a welcome addition to your regular paycheck. But if you read the fine print, you’ll notice the taxes seem like a bigger chunk than those held back from your regular wages. So what gives, and why does the IRS take a larger bite out of your bonus?
To answer that question, it helps to know that bonuses are taxed differently regardless of your tax bracket. Here’s what you need to know about how bonuses get taxed, the bonus tax rate, and how federal withholding works for supplemental income like bonus pay.
Read more: Here are 7 free tax filing options
Are bonuses part of taxable income?
When it’s tax time, a bonus is part of your taxable income, and you’re expected to report it as such for the purpose of federal income taxes. That’s because bonus money is considered a supplement to your regular pay.
The IRS tells employers that “wages subject to federal employment taxes generally include all pay you give to an employee for services performed. The pay may be in cash or in other forms. It includes salaries, vacation allowances, bonuses, commissions, and taxable fringe benefits.”
There are some exceptions to whether a bonus gets added to your tax bill. Company parties and employee discounts or other fringe benefits are generally exempt, as is the occasional meal or gift of nominal non-cash value.
What are supplemental wages?
According to the IRS, supplemental wages don’t have to be cash to be taxable income. The following types of compensation are considered a cash equivalent, are part of your regular income, and are subject to tax withholding.
Signing bonuses or incentives
Severance pay
Accumulated sick leave
Some commissions
Overtime pay
Back pay and retroactive pay increases
Non-deductible moving expenses
The IRS also specifies to employers that “any fringe benefit you provide is taxable and must be included in the recipient's pay unless the law specifically excludes it.” Some of the benefits the IRS excludes from income tax liability include employee achievement awards up to a certain amount, a health savings account up to the contribution limit, employer-provided cell phones, and other types of benefits like tuition or adoption assistance.
How much are bonuses taxed?
If you noticed that your bonus seems to be taxed at a different withholding rate, you’re not wrong. There are two different methods for how much tax the payroll department deducts, but in general federal income tax rates on bonuses work out to be around 22%.
Here’s how the two different methods work for bonus payments and why your employer might prefer one method over the other.
Method 1: The percentage method
Many employers prefer the percentage method because its withholding rate is straightforward. This flat rate method requires your employer to withhold 22% of your bonus, plus an additional 7.65% for Medicare tax and Social Security taxes.
These bonus tax rates apply regardless of your tax bracket up to the first $1 million. If you receive more than $1 million in bonuses, 37% will be withheld on any amount above that. Unless you’re a highly paid CEO or part of the executive team, most people in a lower tax bracket aren’t paying a 22% marginal tax rate. So come tax time, you’ll likely get a tax refund on the excess withholding.
Here’s an example of how it works:
Let’s say you get a $3,000 bonus. Your employer uses the flat rate percentage method and deducts 22% off the top, resulting in $660 of federal tax withholding. But because you’re married filing jointly with less than $89,450 in adjusted gross income, your tax rate is actually 12%. With a flat rate method, the IRS would owe you about $300 on your bonus withholdings come tax time.
Method 2: The aggregate method
Bonuses taxed using the aggregate method can be a bit trickier. Your employer lumps your bonus into one paycheck for a payroll period, then pays tax according to your normal withholding rate, in addition to Social Security and Medicare taxes.
If you’re in a higher tax bracket, this results in less of your bonus in your pocket up front, while those in lower brackets will walk away with more in their paycheck. See the example below to get a better sense of how the way your employer pays taxes on your bonus can change your tax burden.
Returning to the example above, you get a $3,000 bonus and file a joint return on income of less than $89,450. If your employer used the aggregate method, your bonus would already be taxed at 12%, resulting in a withholding of $360. While you wouldn’t get a tax refund, you’d pocket more of your bonus up front.
4 steps to lowering the tax liability of a bonus
Gearing up to get a big bonus this year? You don’t have to be a tax professional to use the following tips on scoring some tax savings.
Step 1: Adjust your withholdings
If the anticipated bonus is large enough to bump you into a higher tax bracket, increase your withholding amount on your W-4 now.
Not sure if you’re withholding at the right tax rate? Here are the current IRS tax brackets and marginal tax rates for each filing status.
Step 2: Reduce your taxable income
Any financial adviser worth their fee will tell you that to lower your tax liability from a large bonus, you should lower your taxable income.
This would include strategies like making charitable donations, claiming applicable tax credits, and maximizing your deductions to account for student loan interest and mortgage interest, business expenses, educational and healthcare expenses, and more.
Step 3: Contribute to a tax-advantaged account
Tax-advantaged accounts are ways Uncle Sam lets you save tax-free (or tax-deferred) for certain big-ticket expenses such as retirement, healthcare, and college.
You can offset the tax burden of your bonus by squirreling it away in an eligible 401(k), IRA, HSA (Health Savings Account), flex spending or other tax-advantaged account as long as you don’t exceed the allowable contribution limit by the end of the year.
Step 4: Defer your bonus
If you think you’ll be making a lot less money next year, don’t hesitate to ask your boss to defer your bonus or split it between this year and next year. Consider this option only if you can wait for the cash or if you expect your personal finance situation to change.
And consider that there is some risk that the chunk of change allotted to you might not be around next year (or you might not be around to receive it). So pursue deferring or splitting a bonus only if you’re confident about your employment status.
Read more: Expecting money back? Here are 5 smart ways to use your tax refund
Frequently asked questions about bonuses and taxes
1. Is my employer required to withhold taxes from my bonus?
Yes. While the amount of taxes can vary, your employer must use the percentage or aggregate model to calculate the federal tax withholding from your bonus. They are required to do so for any supplemental income or cash equivalents that qualify as taxable income.
If you have questions about whether the bonus you received is taxable income, you can consult the IRS guidelines on taxable and non-taxable income here.
2. Are there differences in how bonuses are taxed at the state level?
It’s not just the IRS that counts your bonus as supplemental wages. Several states also apply an added percentage on bonuses for state income taxes. This is usually assessed as a flat rate.
The rate is between 5%-7% depending on where you live and your adjusted gross income, so consult your state tax guidelines for more details about what you’ll owe.
