How are bonuses taxed?

In a nutshell

Cash bonuses are typically considered wages and are treated like income. They are subject to federal, state and payroll taxes.

• Employers pay employees additional compensation (also known as variable pay) in the form of bonuses to attract and retain talent and incentivize and reward performance.
• Employers may award signing, referral, performance-based, milestone, annual or holiday bonuses.
• Noncash bonuses, such as extra time off, don’t impact your taxes.

What is a bonus?

A bonus is a payment in addition to compensation and benefits. Bonuses may be given for various reasons but are usually linked to performance. Sales roles in particular may include a bonus structure as part of the compensation package. According to the Bureau of Labor Statistics, among management, business and financial occupations, the most common employee bonuses include end-of-year bonuses, cash profit sharing and referral bonuses.

Companies employ this tactic because recognition programs are linked to reported increases in employee retention and profitability. Research from Quantum Workplace has found that when employees believe they will be recognized, their engagement increases threefold. Incentive programs can boost employee performance by 44%, according to the Incentive Research Foundation. Not implementing employee recognition programs such as bonus plans can be bad for business, as companies lose approximately $1 trillion due to employee turnover in the U.S. alone.

Bonuses are used across many industries, with employees in finance and banking receiving around 20.9% of their salary as bonuses, those in the technology industry anywhere from 5% to 15%, and from 1% to 5% in health care.

Types of bonuses

Nearly four out of 10 organizations use variable pay to attract and retain employees, but companies may use different types of bonuses depending on their objectives. Organizations may reward individuals, teams or the entire organization in any of the following ways:

• Cash-based bonuses may include a signing or referral bonus to attract top talent, merit-based and annual bonuses to retain employees who have reached their goals, and milestone and holiday bonuses to showcase goodwill and further incentivize employees.
• Noncash bonuses (which are usually not subject to tax) may include additional paid time off, trips and even gift cards. Other perks that employees can benefit from include flexible working arrangements, gym memberships, professional development opportunities and experiential rewards, such as tickets to live music or sporting events.

Other types of bonuses include holiday bonuses, payments in lieu of benefits — for example, when an employer offers cash to employees who waive employer-sponsored benefits, such as sick leave — longevity bonuses and referral bonuses.

How are bonuses taxed?

Bonuses are referred to as supplemental wages and are subject to the same tax withholdings as your regular pay including federal, state, Social Security and Medicaid. Because of this, you should familiarize yourself with the tax laws on supplemental wages in your state of residence if you expect to receive a bonus.

Employers may opt to utilize the percentage method or the aggregate method for withholding. Under the percentage method, bonuses are taxed at a 22% rate for federal tax if the bonus is $1 million or less and 37% above $1 million. In this case, state, local and other payroll taxes are contingent on the employee’s withholdings. Under the aggregate method, the employer combines the bonus with regular compensation, which is then taxed according to your withholding status.

Because bonuses are taxed as regular income, you should check with your accountant if you expect a big bonus. They will help you assess whether the bonus changes your tax bracket and if you should update your W-4 to update the withholdings.

Net pay calculation for bonuses

To calculate your net bonus pay, the percentage method is effective because it minimizes the chance of underpaying taxes and therefore owing the IRS money at the end of the year.

Your net bonus pay can be calculated by subtracting the following from your gross paycheck:

• Federal income tax withholding from the gross bonus amount (22% for bonuses under $1 million).
• Social Security tax (6.2%).
• Medicare tax (1.45%).
• State and local taxes.

Here’s an example of this calculation for a $10,000 bonus:

• 22% federal tax x $10,000 = $2,200.
• 6.2% Social Security tax x $10,000 = $620.
• 1.45% Medicare tax x $10,000 = $145.
• Taxes withheld = $2,965.
• Net bonus = $7,035.

If your employer combines your bonus with your regular pay using the aggregate method, the withholdings will vary according to your specific withholdings.

Tax planning strategies for bonuses

To implement a viable tax strategy for bonuses, first consult with an accountant to determine your tax bracket and how additional wages could potentially change this.

To limit the amount of your bonus that is paid in tax, you can increase contributions to tax-advantaged accounts such as a 401(k) or IRA retirement plan or 529 plans for education as long as you adhere to the limits set by the IRS. Paying off medical bills and increasing your health savings account (HSA) pretax contributions for high-deductible plans can also help with tax planning.

Finally, you can ask your employer to delay the bonus payment until the following year so that it does not impact your current year’s tax bill.

How to minimize tax on bonuses

To help minimize tax on bonuses, consider applying the bonus to pretax contributions for retirement, educational or health-related purposes, and make sure you have paid deductible expenses before the end of the year. Charitable donations can also reduce taxable income if you itemize.

Can you avoid taxes on bonuses?

No, taxes cannot be avoided on bonuses. However, you can defer compensation, increase contributions to tax-advantaged accounts such as a 401(k) or IRA, or pay for items that can be deducted such as medical expenses, provided you itemize deductions on your return and they exceed a certain percentage of your income.

The AP Buyline roundup

Bonuses have grown in popularity, particularly because recognition of employees has been linked to higher performance. Cash bonuses are considered income and are therefore taxable. If you’re fortunate enough to receive a performance or signing bonus, or a bonus for referring someone in your network, make sure you understand the tax implications. Contributing to tax-advantaged accounts to minimize tax payments at the end of the year is one way to minimize the tax hit.

Frequently asked questions (FAQs)

Are all types of bonuses taxed the same way?

No, different bonuses are taxed differently. Employers may decide to tax the bonus using the aggregate method or the percentage method. The aggregate method combines the bonus with your wages for that time period and applies withholdings. The percentage method taxes bonuses under $1 million at 22% and over $1 million at 37%. All bonuses are considered supplemental wages.

Can I change my withholding for a bonus?

To change withholding for a bonus, ask your employer whether you can opt into the aggregate method. This way, your paycheck and bonus are taxed as one, increasing your withholdings and thereby decreasing your chance of underpaying taxes and possibly owing money to the IRS. If you overpay, you’ll be entitled to a refund when you file your taxes.

How do bonuses affect my tax refund?

Bonuses increase your taxable income at the end of the year, which could potentially push you into a higher tax bracket. Bonuses can also impact your eligibility for other deductions. Any withholding miscalculation could lead to over or underpaying taxes. It is important to consult with a tax professional to assess the impact of a bonus on your overall tax scenario. You should also double-check your withholdings with your employer to make sure they are correct.

What if my employer doesn’t withhold enough taxes?

If your employer does not withhold enough taxes, you will owe the difference when you file your tax return. The IRS may also impose additional penalties. If you’re concerned about penalties, you can make estimated payments throughout the year to close this gap.

If you expect a large bonus, submit a new W-4 to your employer to increase withholdings. You can assess your tax liability by reviewing your paycheck stub and modifying your W-4 if necessary. The IRS provides a tax withholding calculator so you can plan appropriately. In any case, set aside money for any potential shortfalls around tax season.