Bonuses can be a welcome bump in pay, but the difference between what your employer promises you and what you actually receive can be startling. That’s because your employer must withhold taxes from your bonus — and those taxes can take a big bite.
Employers have two options for how much tax to withhold on bonuses: They can apply a standard 22 percent rate, or they can treat the bonus as part of a regular paycheck, and use a similar withholding rate.
The good news? If too much is withheld from your bonus, then you should receive a tax refund when you file your tax return.
How are bonuses taxed?
The IRS generally classifies bonuses as “supplemental wages.” Other types of supplemental wages include severance pay, commissions, and awards and prizes.
Just as your employer holds back a portion of your regular paycheck to pay your taxes, it must take money out of your bonus check, too. These funds are sent to the IRS on your behalf. (This process is known as tax withholding, and you can control your withholding rate by how you fill out your Form W-4.)
Supplemental wages are subject to either a flat 22 percent federal withholding rate or a withholding amount based on your marginal tax rate. Your employer chooses which withholding method to use.
Here’s how it works: Employers are allowed to calculate tax withholding on your bonus in one of two ways — the percentage method or the aggregate method.
The percentage method
The percentage method, also called the flat rate method, is the easiest way for employers to calculate taxes on a bonus. With the percentage method, the employer identifies the bonus as separate from your regular wages. The withholding rate for supplemental wages is 22 percent.
That rate will be applied to any supplemental wages, such as bonuses, up to $1 million during the tax year. If your bonus totals more than $1 million, the withholding rate for any amount of the bonus above $1 million is 37 percent.
Percentage method examples
Below are two examples of how the percentage method works.
Example 1:
| Bonus amount | $10,000 |
| Federal tax | $10,000 X 22% = $2,200 federal income taxes withheld |
| Remaining bonus | $7,800 |
Example 2:
| Bonus amount | $1.5 million |
| Federal tax | $1 million X 22% = $220,000$500,000 X 37% = $185,000
$220,000 + $185,000 = $405,000 federal income taxes withheld |
| Remaining bonus | $1,095,000 |
Note: If your supplemental wages for a year total more than $1 million, your employer must use the flat rate method and calculate your bonus withholding over $1 million at 37 percent.
The aggregate method
Sometimes employers pay bonuses alongside regular wages. In this situation, your employer must use the aggregate method to calculate the tax withholding on your bonus.
With the aggregate method, the tax withholding on your bonus is calculated at your regular income tax rate. The withholding rate is based on your tax bracket. Often, when taxes on wages plus bonuses are calculated together this way, the total amount of tax withheld is higher than if the employer used the percentage (or flat rate) method described above for the bonus.
Aggregate method example
Imagine your typical monthly salary is $6,000. Your tax withholding would be based on an annual salary of $72,000 ($6,000 X 12). That income amount would put you in the 22 percent federal tax bracket, assuming you file your tax return as single or head of household. (That 22 percent rate is your marginal or top tax rate.)
Continuing with this example, let’s say that in November your employer pays you a bonus of $10,000. The employer gives it to you alongside your regular $6,000 monthly salary but identifies it as a bonus. Your income climbs to $16,000 for that month.
Using the aggregate method, your employer would multiply $16,000 by 12 months. This would cause the tax withholding on your bonus to be calculated as if you were earning $192,000 per year, bumping you up to the 32 percent tax bracket. The employer would subtract the taxes already withheld from your last paycheck and take the remainder out of your bonus amount.
Exceptions to the rules
The IRS will expect its cut of any bonus you receive. Even if you receive your bonus in cash, gift cards, a vacation or some other benefit, you’ll generally have to pay taxes.
The exception to this rule is if your bonus can qualify as an employee achievement award. You might be able to avoid paying federal income taxes under the following conditions:
- The award isn’t cash, a cash equivalent (such as a gift card or money order), tickets to events, vacations, stocks, bonds or other prohibited items.
- The award is tangible personal property.
- The total value of the award doesn’t exceed $1,600.
Tax withholding can mean a tax refund, or a bill
The method your employer uses to calculate the federal withholding on your bonus can have a big impact on your take-home pay. Still, you won’t know how much you actually owe the IRS until you file your tax return the following year. If it turns out that the tax withholding on your bonus was higher than necessary, you might receive a tax refund for overpayment.
On the other hand, if too little money was withheld from your income throughout the year, you could wind up owing the IRS. You can reduce the risk of owing the IRS money by reviewing your Form W-4, which tells your employer how much to withhold from your paychecks. The IRS Tax Withholding Estimator is a useful tool for figuring out exactly how much money you should have withheld for taxes. Also, if you receive a large bonus or your financial circumstances change, it may be best to talk to a tax professional for advice.
How to lower your tax withholding on a bonus
Want to lower the amount of taxes withheld from your bonus? Consider asking your employer to pay your bonus separately from your regular paycheck, and to calculate your tax withholding at the 22 percent flat rate the IRS allows for supplemental wages.
Another strategy is to stash your bonus into a pre-tax account such as a 401(k) or IRA (assuming you haven’t hit the contribution max for that account). The taxes will already have been withheld before you can make that contribution, but you should receive that money back as a refund at tax time. Using a pre-tax account shields the bonus from being counted in your taxable income in the current year. (You will, however, owe income tax on money you withdraw from those accounts in retirement.)
What are supplemental wages?
The IRS considers bonuses to be “supplemental wages.” A supplemental wage is money paid to an employee that isn’t part of his or her regular wages, according to the IRS.
In general, bonuses of any kind, including signing bonuses and severance pay, fit into the supplemental wages category. Examples of supplemental wages include, but aren’t limited to:
- Bonuses.
- Certain commissions.
- Overtime pay (employer can choose to categorize as supplemental or regular wages).
- Accumulated sick leave.
- Severance pay.
- Prizes and awards.
- Back pay.
- Reported tips (employer can choose to categorize as supplemental or regular wages).
- Retroactive pay increase.
- Payments for non-deductible moving expenses.
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