How are bonuses taxed?

What is a bonus?

A bonus is an additional compensation award to a worker on top of their salary. Companies offer bonuses for different reasons, depending on what they’re trying to accomplish. Standard bonuses include retention bonuses for highly valued employees, profit bonuses at the end of the year and referral bonuses.

Whatever the reason, the IRS considers a bonus a supplemental wage, a payment outside the scope of an employee’s regular wages.

That said, the IRS considers some benefits — which it terms “de minimis fringe benefits” — to be too unrealistic to account for. These include occasional holiday gifts, snacks, event tickets, meal money, transport money while working overtime and flowers for special occasions.

Bonus tax rate

The IRS can withhold 22% of your bonus if it’s under $1 million. It can withhold at the highest tax rate (37%) any bonus amount over $1 million. The ultimate amount the bonus is taxed depends on your total income.

The “supplemental wage” applies to bonuses, overtime pay, severance pay, commissions, prizes and several other categories of payments.

Bonus payments are also subject to Medicare, Social Security and FUTA (the Federal Unemployment Tax Act) taxes. In addition, depending on your area of residence, your bonus might require local or state taxes.

How bonuses are taxed

Employers have two ways to handle bonus taxes; they can either withhold a flat 22% or use the aggregate method.

The 22% flat rate method

For this method, you receive your bonus separate from your regular paycheck, and the withholding is calculated independently.

If your bonus is less than $1 million, there is a flat 22% rate; any amount above $1 million is taxed at 37%. Two examples:

• If Olivia receives a $5,000 bonus, her withheld amount will be $5,000 x 0.22 = $1,100
• On the other hand, if Jerry receives a bonus of $1.8 million, his taxes will be as follows:
  • $1,000,000 x 0.22 = $220,000
  • $800,000 x 0.37 = $296,000
  • Total withheld from bonus: $220,000 + $296,000 = $516,000

The flat tax rate is easy to calculate, and you can see exactly how much of your bonus money was withheld for taxes. However, whether some of that bonus money is refunded by the IRS or you owe more to the government depends ultimately on your total taxable income.

The aggregate method

For the aggregate method, your employer lumps the bonus with the employee’s wages and withholds taxes as if the total amount is a single payment for a regular payroll period. In this case, the withholding is dictated by the information in your W-4. This generally results in less chance of you owing a large amount of taxes or receiving a large refund when you do your taxes the following year.

How to minimize the tax impact of a bonus

According to Eric Croak, a certified financial planner and the president of Croak Capital in Toledo, Ohio, there are two main ways to deal with the taxes you pay on a bonus. “First, you can lower your gross income. Second, you can get more tax deductions that apply to your income,” Croak told us.

While your employer is responsible for withholding the tax from your bonus, you can do a few things to reduce the bonus's impact on your tax.

Confirm your bonus is taxable

Before you take any action, ensure your bonus isn’t actually a de minimis fringe benefit — these are benefits that are impractical to account for, like occasional tickets, holiday gifts and meal money for working overtime. De minimis benefits are not taxed. Remember, cash and gift certificates are taxable.

Spend your bonus diligently

You can invest in a tax-advantaged account for tax relief. For example, if you haven’t hit your maximum annual contribution on a traditional retirement savings account, consider contributing more. Contributions to a 401(k) or traditional individual retirement account (IRA) can be deducted from your taxable income to lower your tax bill.

Another option is your health savings account, if you have one.

“If your health plan has a high deductible, you might be able to put money into a health savings account (HSA),” Croak told us. “These donations take away the same amount from your gross pay as the donation. You can also take money out of an HSA to pay for qualified medical costs without having to pay taxes on the money. This is one of the best ways to handle your taxes.”

Defer your bonus

There are instances where deferring a bonus could lower the tax stress. For example, if your income the next year will be lower than your current year, delaying your bonus to the next year could lower the tax liability. Also, if the bonus will push your tax bracket higher, deferring the bonus might allow you extra time to save up for the taxes you owe.

Review your W-4

Bonuses can happen at any point of the year, and when they’re added to your wages, they inflate your earnings and might even push you to the next tax bracket.

This is why you need to do a little W-4 maintenance and adjust your withholdings. This will help you get a sense of how much you’ll owe and whether you have zeroed out your tax liability or will be getting a refund.

Bottom line

Receiving a bonus is exciting mainly because it means more money for you. However, the bonus is taxable at the same rate as your regular wages, and how much of it you receive immediately depends on how your employer decides to pay it — with your regular wages or separately.

Educating yourself on how bonuses are taxed can help you manage your expectations and make informed financial decisions about how to spend your money.

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