For some fortunate workers, a new year means a bonus is coming. That can be good news since some companies are cutting budgets, laying off workers, or scrapping bonus pay or salary increases altogether.
However, people are often surprised when the amount they receive from an announced bonus is much less than expected. That situation — where a big chunk seems missing from your bonus pay — is due to federal tax withholding and so-called bonus tax rates.
Even though you cannot eliminate bonus tax withholding, it is helpful to understand how bonuses are taxed so that you know how much money to expect. Knowing how much bonus pay will arrive in your account can help with tax planning. That might involve navigating tax changes and trying to offset income through tax deductions, credits, and exemptions.
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Why is my bonus taxed so high?
When you see that the amount of your bonus check or direct deposit is less than your employer-promised bonus amount, it’s most likely because your employer has withheld taxes from your bonus. (Although, it is always important to double-check the amount of your bonus as described by your employer.)
- First and foremost, bonuses are taxed because they are considered taxable income. But the IRS also considers bonuses to be supplemental wages.
- Essentially, supplemental wages are types of wages, e.g., overtime, commissions, etc., that aren’t regular wages.
- When your employer pays supplemental wages, they are supposed to follow payroll tax rules and withhold a portion of those wages (in this case, your bonus), for taxes.
The amount that is withheld from your bonus depends on the withholding method that your employer uses, which depends, in part, on the amount of your bonus, and how your bonus is paid.
Federal bonus tax rate: How bonus tax withholding works
Percentage Method: The first supplemental wage tax withholding method is called the percentage method. This method is typically used when your bonus check is issued separately from your normal paycheck.
- The percentage method means that if your bonus is less than $1 million, your employer automatically withholds a flat 22% from the bonus for tax.
- If you earn commission or have ever received severance pay, you may also have had the flat 22% withheld because those types of pay are also usually considered to be supplemental wages.
So, for example, if you’ve been told that you are receiving a $5,000 bonus, and your employer uses the flat percentage method, they should withhold at least 22%, which based on this example would be $1,100.
If your bonus exceeds $1 million, the flat percentage withholding would be 37% of the amount of your bonus that exceeds $1 million. Thirty-seven percent correlates to the top federal income tax rate.
Aggregate Method: The other method for withholding from supplemental wages is the aggregate method. This is typically used when your employer pays your bonus money along with your regular pay in a single payment.
Under this method, your employer withholds tax in accordance with a formula based on the information that you provided on your W-4 Form.
Note: The aggregate withholding method can cause some confusion and frustration for people. That’s because your regular and bonus pay are combined as a lump sum. As a result, the amount of tax taken from the check that includes your bonus pay is higher than what you’re used to with your usual paycheck on your regular payday.
Remember that other standard income and payroll taxes (e.g., state taxes, Social Security taxes, etc.) are also withheld.
Can you avoid taxes on your bonus check?
Because your employer is required to withhold, you can't avoid the tax on your bonus. But it can understandably be frustrating to receive compensation for a job well done and then find that much of that money goes to taxes.
With that said if you’re curious about how much your bonus payment might impact your taxes, the IRS has a calculator that can help estimate your withholding before you file your tax return. And, when you file your federal income tax return, it turns out that too much tax was withheld (based on your income and tax rate), you could look forward to a tax refund.
On the other hand, if you’re worried that your bonus will be large enough to bump you into a higher income tax bracket, you could consider deferring your bonus to the next tax year.
For example, if your company plans to pay your bonus in December (and you expect to have less income in the coming year) you could ask to have the bonus payment deferred. (Your employer doesn't have to agree to this.)
If your bonus is paid at the end of the year, you might offset your bonus and other taxable income with some year-end tax moves. Tax deductions for donations to charity or contributions to your retirement savings account can reduce your tax liability.
But remember: Dec. 31 is the deadline each year for making many contributions for tax purposes that might help offset a year-end bonus.
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