A bonus is never a bad thing, and can be a sight for sore eyes in a paycheck. Working hard to help your company achieve its annual goals should be rewarded in a fair and proportional way.
However, bonuses are taxed differently than your regular income by the IRS.
They also count towards an income in a given tax year, so much like regular income they’re subject to income tax.
In the eyes of the IRS, a bonus is called a “supplemental wage” and as such carries a flat rate federal withholding of 22%.
How Is “Supplemental Wage” Defined?
Bonuses, according to the IRS, fall into a bracket of income called “supplemental wages.”
These are defined as being money paid to an employee in addition to their regular wages.
There are a number of categories the IRS defines as being supplemental wages, these include but are not limited to things like:
- Signing Bonuses
- Severance Pay
- Back Payments
- Payments For Moving Expenses
- Backdated Pay Increases
What Is Tax Withholding?
An employer is legally obligated to hold back a portion of your wages so that they can prepay your taxes.
The same function applies to taking money out of a bonus payment.
The process of taking money from a bonus check and sending it to the IRS on your behalf is known as tax withholding.
Employers typically use either the percentage method or the aggregate method when they calculate your liable tax withholding.
The Aggregate Method Explained
In certain circumstances, an employer may pay you a bonus alongside your regular wage.
If this is the case, they would need to use the aggregate method to work out your initial tax withholding on the bonus.
This is often a nightmare for your employer. They would need to figure out the tax withholding and potentially extra money withheld in the bonus check.
Using this method, your tax withholding on the bonus is calculated using your regular income tax rate. In addition, your tax bracket determines your withholding rate.
This means that, most of the time, initial tax withholding is higher when taxes plus wages are calculated together.
The Percentage Method Explained
Also known as the flat rate method, the percentage method is by far the easiest way to calculate taxes on bonuses.
Unlike the aggregate method, it usually also translates to more money in the pocket of the employee.
Using this method, employers must first discern a bonus as being separate from your regular pay.
As the bonus is defined as being separate, it falls under the supplemental wages category and is therefor taxed at the withholding rate of 22%.
This 22% rate is applied to all money falling into the supplemental wage’s category up to $1 million in a tax year.
Anything in excess of $1 million is taxed at a 37% rate.
However, alongside this 22% (or 37% depending on total amount) federal tax, you are also liable to pay FICA (Social Security tax), Medicare tax, and state income tax (although the last one is subject to the state you live in).
The combined FICA and Medicare tax rate sits at 7.6%.
When discussed as individual taxes, Social Security is taxed at 6.2%. Employees pay Social Security taxes on the first $142,800 earned.
This is what’s called the Social Security wage base limit. It’s worth noting that this limit has increased year-on-year
There is no wage base on Medicare, with the current rate being 1.45%. There is no limit on Medicare taxes, and employees will pay an extra 0.9% if your earnings exceed $200,000 in a tax year.
Are There Exceptions To These Rules?
The short answer is, tentatively, yes there are exceptions to the rules. That being said, the IRS will expect a cut of any and all bonuses you are paid.
This applies to bonuses paid in the form of cash, gift cards, vacations or other benefits.
If your bonus can count as an employee achievement award, you might be able to avoid federal income taxes. There are conditions to this, these are:
- The award cannot be cash or a cash equivalent (gift cards for example)
- The award is personal property
- Its total value isn’t in excess of $1,600
Is There Any Way To Lower Tax Withholding On Your Bonus?
It’s worth considering asking your employer if they will pay your bonus in addition to your regular paycheck.
If so, you can check to see if your employer can calculate tax withholding at the 22% set out by the IRS for supplemental income.
The method your employer uses to work out your federal tax withholding on a bonus has a huge impact on your pay check.
Even so, you won’t be able to calculate how much you actually owe in taxes to the IRS until it’s time to file your tax return the next tax year.
If you have overpaid your tax withholding, you are entitled to a tax refund.
The opposite is also true, and if too little was withheld over the year, you could owe the IRS it’s cut.
By reviewing your W-4 withholding, you might be able to manage and reduce the risk of owing money to the IRS.
It’s advisable to consult a tax professional, especially if you’re in a position where you are due to receive a large bonus, or you expect your financial situation to to change.