Bonuses are the additional monetary benefits to wages and are added to the regular income while calculating tax by the IRS. The employer can calculate how much to withhold from your paycheck using two ways.
Getting a bonus is a very delightful and motivating reward for employees to boost their spirit. After all, everybody deserves some cash for self-love and some appreciation to feel valuable and incentivised. For some individuals, it is a shocker to know that the bonuses are also taxed. When they receive their paycheck, they go, “Oh! Hold on, bonuses get taxed” when they receive their paycheck.”
Bonuses are also taxed; this is quite true and clear. And how they are segregated and computed depends on several parameters, which include the calculation method used by your employer.
Don’t worry! We have backed you up. Here’s a guide to how bonuses are taxed and who pays? This article also deals with the two methods employers usually use to calculate your withholding and some pro-tips for reducing the effect of tax on your bonus.
- What is a Bonus?
- How are bonuses taxed?
- The two methods of calculating tax withholding on bonuses
- How to minimise the tax impact on a bonus
- Summing Up
What is a Bonus?
A bonus is a direct cash or indirect monetary benefit paid to an employee based on his performance over a period of time at the company’s discretion. Bonuses are generally lump sums or a certain percentage of the employee’s base salary, which is rolled out in addition to a worker’s pre-existing salary or wage.
In general, bonuses are distributed on certain auspicious occasions, such as on a holiday, or scheduled according to the compensation plans, for instance, to achieve a quarterly sales goal. Several other types of bonuses include joining, annual, merit, relocation, referral, sign-on and retention bonuses.
How are bonuses taxed?
The IRS considers any bonus you receive as a regular income. For starters, a portion of the bonus will be withheld from your paycheck by your employer as pre-tax. This doesn’t end here; you may also have to pay state taxes, medicare and Social Security taxes (also known as FICA taxes) on the bonus you get.
In some cases, the bonus will be added to your total income for the year in the longer run. The total amount you receive as bonuses for the year will be clubbed with other earned income and listed in Box 1 of your W-2 form.
At the end of the financial year, when it is time to file your annual taxes, the total income component will include your bonuses, and the amount will get taxed according to the rate. Employers usually withhold some amount from your salary every month and prepay the tax on your behalf to reduce the burden on you. If the taxes are withheld accurately, you don’t know anything about the IRS. If an excess amount is withheld, you will get a refund, and if some amount is due, you will get a tax bill.
The two methods of calculating tax withholding on bonuses
In contrast to the regular income, the IRS adds bonuses and other payments such as severance pay or commissions to a separate category known as “supplemental wages”. This is where ambiguity begins.
The bonuses are finally taxed as regular income by the IRS, yet your employer can pick any of the two different methods for calculating the tax withholdings. In simple terms, your employer has an option to choose how he wants to do the math on your paycheck. And the method he chooses eventually determines how much tax you have to pay at the end of the year.
1. The Percentage Method
In case your employee rewards you with a bonus other than your regular page checked, it is quite probable that they will use the percentage method to calculate the amount of tax to be withheld on your bonus.
If the total bonus amount is under $1 million, your total bonuses for the year will get taxed at a flat rate of 22%.
If your total bonus amount is higher than $1 million, the initial $1 million is taxed at 22%, and every excess dollar is taxed at 37%. If the bonus amount goes over $1 million, your employer should use the percentage method.
Pros: The prime advantage of the percentage method is that it is considerably simpler for the employee. Hence, it is quite popularly used by people.
Cons: The prime shortcoming of this method is that most people have a lower effective tax rate than 22%. If you come under the higher tax bracket, there is a possibility that not much of your bonus was withheld for taxes, which might be a shocker for you as a tax bill at the end of the year. In contrast to this, if you come under the lower federal tax bracket, your bonus might get taxed at a higher rate than your regular income. This implies an excess of your bonus will be withheld, so you may get a tax refund when you file the taxes.
2. The Aggregate Method
The aggregate method is usually used when your employer clubs your bonuses and regular wages/income/salary into a single paycheck.
Your payroll department will withhold taxes on the entire aggregated payment at the same rate. That withholding rate depends on your filing status and the information you provided on your W4.
Pros: Even though it is not absolute, the aggregate method has a higher probability of making sure that your withholdings are enough to cover your tax liability. In short, there is a scope of the minimal surprise tax bills due to your bonus amount. It might also get you a tax refund, which is a positive thing.
Cons: It increases the workload on the employer as there are more calculations and guidelines, and there is a possibility to withhold too much, which implies a higher deduction out of your paycheck than required.
How to minimize the tax impact on a bonus
There are a few concise methods that you can use to reduce the tax impact on your bonuses to reduce reliability at the end of the year:
1. Review your W-4 carefully
2. Make sure your bonus is genuinely taxable or not
3. Claim tax deductions
4. Contribute to a tax-advantaged account
5. Defer your bonus
You can have a clear understanding of how bonuses are taxed, but the vital decisions and the choice of calculation methods lie in the hand of your employer. It is good to be aware and well-calculated of your tax liabilities to make sure that you take care of your financial well-being effectively.