Nothing beats the feeling of appreciation when receiving a cash bonus from your employer for a job well done. Before you start spending that cash on bills, investments, or splurge items, plan for the tax implications. You might keep less of that bonus than you expected.
Because it’s not directly earned, the IRS looks at bonuses differently than regular income.
How Employer Bonuses Are Taxed
Even if your employer adds your bonus into your check, the IRS views them differently than regular income. Bonuses are considered supplemental income rather than standard wages.
Supplemental wages can include:
- Sick leave
- Non-deductible moving expense payments
- Severance payments
- Retroactive pay increases
- Taxable fringe benefits
- Back pay
- Overtime pay
- Reported tips
Employers can count overtime and tips as regular wages if they want to
Bonus Tax Methods
The IRS taxes employer bonuses in one of two ways: Percentage or Aggregate method.
Taxed by Flat Percentage
Using the percentage method, the IRS treats bonus income more like gambling winnings than a paycheck. Your employer will issue a separate check and withhold a flat 22% of your bonus for taxes.
Taxed by Aggregate Amount
If your employer adds your bonus pay into your regular check, they will withhold amounts according to your W-4 form. For example, if you usually withhold 27%, your employer will withhold 27% instead of 22%.
Fortunately, in many cases, you will see this money again. It can come back to you in the form of a tax return in the next year.
Also worth noting, you can update your W-4 at any time during the year. Just talk with your employer and fill out the form to reflect your current circumstances. The change should take effect on the next paycheck.
Employer Bonuses Over $1 Million
The IRS charges higher taxes on employer bonuses exceeding $1 million.
The employer withholds 22% for taxes on the first $1 million and 37% after the first million.
If you receive a bonus of $1 million or more, you are very fortunate!
Other Taxes for Employer Bonus Pay
You may also pay additional taxes beyond the federal withholding.
Also, you might face a 6.2% Social Security tax and 1.45% Medicare tax in some cases.
Keep these additional taxes in mind before fully committing your employer bonus to bills, savings, or something fun.
Offsetting Employer Bonus Taxes
If you’re delighted about a bonus but bummed about the taxes, chin up. You may qualify for some useful tax deductions or credits.
You can offset the tax liability by using some or all of your bonus to contribute to your retirement account. The IRS offers the Saver’s Credit for people that save money in tax-qualified accounts like a Roth IRA or Traditional IRA.
Make sure to complete your contribution and fill out this information on your tax return before filing. You can make a retirement contribution for the previous tax year as late as April 15 of the following year.
The younger you are, the more powerful those retirement contributions are. The longer you can leave them in a retirement account, the more they will earn for you.
Although they probably won’t provide you with tax deductions, consider prepaying some large bills, like property taxes or yearly insurance ahead of time. That way, when their due dates roll around, you do not need to scramble to gather a large sum of money.
If you have not already, establish an emergency savings fund. Consider protecting your bonus wages for a rainy day, like a down payment, unexpected layoff, or disability.
Tax Withholding Amounts
You can quickly determine how much your tax withholding would be. The IRS’s website offers a helpful tool to help you estimate your tax withholding so that you can prepare your tax strategy for the year.
Enter your income and qualifying deduction information to get an accurate snapshot of your tax liability.
Consider Your Tax Filing Status
Your tax return might be more complicated if your tax filing status changed in the same year you received an employer bonus.
The IRS has an excellent resource to help taxpayers understand the tax codes and answer questions. Millions of people have queries every year, so that’s why the IRS provides a hotline you can call and talk to a live rep. They are there to help you, not get you in trouble.
If you’re struggling with complicated taxes, try calling the IRS, or find a qualified tax professional in your area.