Bonuses are like rewards paid by your employer. They are brownie points in the form of cash from your boss for performing well. It’s like a pat on the back and improves your confidence. However, this money is also taxable by the IRS. The bonus tax rate depends on a number of factors including the way your employer calculates your salary.
Here is a full guide on the bonus tax rate, the methods your employer can use to calculate the money they can withhold, and how to lessen the impact of tax on your bonus money.
What is a bonus?
As mentioned above, bonuses are extra rewards in the form of cash that is paid by your employer. You can receive your bonus for performing well like acquiring your target or generating ‘n’ number of leads for the company. Some companies offer bonuses when there’s a celebration at the office like completing 5 years in the industry or getting recognized globally for their contribution toward the society. Furthermore, some companies like to give out bonuses to all the employees during festive seasons and holidays like Christmas and Thanksgiving.
How are bonuses taxed?
In the eye of the IRS, both salaries and bonuses are the same. For them, any kind of income is taxable. A portion of your bonus will be held back by your employer for tax purposes. When you receive the bonus, you will further have to pay money in the form of state taxes and Social Security taxes.
This bonus will be added to your total amount of income during that calendar year and will be shown in Box 1 of your W-3 tax form. While you are filing your annual taxes, this bonus money will also be taken into consideration and you will have to pay tax money on that bonus amount as well.
The reason why your employer holds back your tax money is that they pay that money on your behalf. If your employer has paid off all the money you owe on tax already, then you won’t have to pay anything. Moreover, if you or your employer has paid more than what you owe in taxes, you will be refunded that money.
Tax withholding on bonuses
The bonus comes under the category of ‘supplemental wages’ by the IRS which also includes things like severance and commission. This is where confusion sets in because the IRS confuses bonuses with severance and commission. To avoid this and save money on your tax, your employer can use two different methods of calculation.
These two calculation methods are of utmost importance because not only do they affect how much you get paid as a bonus but they also affect how much you will have to pay the IRS as tax. The two ways of calculating how much money to withhold in the bonus or any other kind of supplemental wage are:
- Percentage method
- Aggregate method
The percentage method of calculating the bonus tax rate
When your bonus and salary are credited separately or by using two different checks, then there are chances your employer is using the percentage method to withhold money from your bonus pay. If your bonus pay is under $1 million, a flat rate of 22% gets deducted.
On the other hand, if your bonus amount is more than $1 million, then the deduction happens twice. The first $1 million gets taxed at the rate of flat 22%, whereas every single dollar beyond the one million gets taxed at 37%. If your bonus is more than $1 million, then your employer will usually use the percentage method to deduct the money.
How the percentage method works
Scenario 1: Sam gets paid less than $1 million
Let’s imagine Sam has received a bonus of $4000. The employer will withhold 22% of that money for tax purposes. The money taxed will be about $880. So, Sam is paying $880 as tax on just his bonus money.
Calculation: $4,000 x 0.22 = $880
Scenario 2: Emma gets paid more than $1 million
Emma has received a whopping bonus of $2 million from her employer. Here, the first $1 million will get taxed at 22% and the money above that gets taxed at 37%. Out of $2 million, $590,000 will be withheld by her employer for tax purposes.
$1,000,000 x 0.22 = $220,000
$1,000,000 x 0.37 = $370,000
Now, $220,000 + $370,000 = $590,000
The benefit of the percentage method
This is the most common way an employer calculates the bonus money that has to be withheld because it’s easy and hassle-free.
The drawback of the percentage method
The disadvantage of this method is that if your tax is less but you still get taxed at a 22% rate, then you will end up paying more in taxes. But you don’t have to worry about that because your money will be refunded by the IRS at the end of the calendar year. But if you come under a higher tax bracket and end up paying less because of the percentage method, then you will receive a surprise tax bill at the end of the year.
The aggregate method of calculating the bonus tax rate
This is the second method your employer can deploy to cut money from your bonus for tax. The aggregate method is done when the employer clubs both your income and your bonus in one paycheck. The tax will be deducted collectively from both the tax and salary in one go. The money your employer holds depends on the information you have given on your W-4 form.
How the aggregate method works
John’s bonus and salary are credited through a single paycheck. Let’s say John is receiving his payments once in two weeks. His salary is $2,000 and he suddenly receives a bonus of $550. Now, John’s earnings are $2,550. A total of $284 will be deducted to pay tax from his paycheck.
The benefit of the aggregate method
This is not the perfect method to calculate tax deduction but this will cover just exactly how much you will have to pay and will save you any surprise tax bill at the end of the year.
The drawback of the aggregate method
It will double the work for your employer as the task of aggregate calculating is strenuous. This method may also cut more than what’s required and you will end up receiving less money. In that case, you will receive a refund by the end of the year.
How to minimize the bonus tax rate
Now that we know how bonus tax is calculated, let’s find out how you can minimize the tax withholding on your reward money:
Take a look at your W-4 form again
You don’t know when you will receive a bonus and most of the time, bonuses get added little by little. Unlike your salary that’s credited every month, bonuses are rare and happen once in a blue moon. For example, you are likely to receive a bonus just once or twice a year. This extra money has increased your earnings. Thus pushing you into a new bracket of taxpayers. Meaning, you will have to pay more tax if you earn more money.
Before or after you receive your bonus, take a look at your W-4 form. Do a little maintenance check with the help of a W-4 calculator and find out how much to withhold and how much to pay. This will let you know if you have to pay more or if you are liable to receive a refund.
Find out if your bonus is actually taxable
Sometimes the IRS rules out a few earnings and doesn’t consider them taxable income. You just have to find out if your bonus is tax liable or not. Check with your tax professional if you are liable to pay tax for the amount you have received as a bonus or not.
The tax deduction is the most important step when you are filing your tax. It helps you save money. Check out what things you can save your money on and then write them off on taxes.
Contribute to a tax-advantaged account
When you are trying to lessen the tax amount, this is one of the best ways to do it. When you have a tax-advantaged account and you have reached your contribution limit already, then use your bonus and only a minimal portion of it will get deducted since you’ve already contributed. Not only are you paying your taxes in your tax-advantaged account, you are also saving money for the long term.
Defer your bonus
Some people tell your employer to postpone their bonus till the next year. This doesn’t mean they won’t have to pay the tax. It’s just that you will pay the tax at a later date. This tactic makes sense if you think your bonus money will categorize you in a higher tax bracket. This gives you extra time to save money in order to pay your taxes.
Another reason why people opt for this strategy is that they think if their income next year is less, then they will be liable to pay less tax the next year. All these are tricky strategies and that’s why it’s crucial to talk to a tax professional to find out how you can navigate your financial situation in a better way.