How Are Bonuses Taxed?
Your Bonus Has Arrived!
If you expected an end-of-the-year bonus, the payout usually happens within the first few months of the new year. This seems contrary to its title, but you can overlook the timing due to a cash windfall you get dropped into your bank account. It can be exciting to see supplemental income, but it is a little confusing that the IRS does not consider a bonus a regular wage. Instead, thanks to certain Federal (and sometimes State, too) withholding rules that apply, you receive a lower amount than you might have anticipated using a Bonus Tax Rate.
How is Your Bonus Taxed?
There are two possible methods to determine how you’re taxed on your bonus: the first is the percentage method and the second is the aggregate method. Most people fall into the flat 22% rate on a bonus outside of your normal paycheck. For example you expect a $10,000 bonus and only receive a deposit for $7,800.
Occasionally, bonuses can be added to your regular paycheck and affects your tax bracket and is a little more complicated. In this case you add the bonus with your base pay and together they withhold more throughout the year.
How Does the Percentage Method Work?
The percentage method is basic and easy to apply. Employers withhold the flat rate required by the government. The average American bonus is under $1 million dollars and has a 22% tax rate. If you’re lucky enough to earn more than $1 million in a bonus, you are taxed at a 37% rate. Incidentally, your first $1 million is taxed at the 22% rate but any money over that starts at the 37% rate. The percentage rate only gets complicated when your tax bracket is not at 22%. If your income tax rate is lower than 22%, you could be getting more withheld at a higher rate – and conversely if it is higher than 22% you aren’t withholding enough with this method.
How does the Aggregate Method work?
The bottom line of this method is – the more you earn, the more tax you pay. An employer adds your bonus to your base pay and assumes that higher rate will continue all year and withhold the taxes based on that number.
Instead of that $10,000 bonus dropping $7,800 in one lump sum like it did in the percentage method, that same $10,000 would be added to your base pay and divided by your total pay periods over twelve months. When you file your taxes, the amount earned could put you in a different tax bracket and change the percentage rate. The pro for this method is that withholdings tend to be closer to what you actually owe the government.
Either method would have to be reconciled during tax time anyway to ensure you were taxed correctly. What you really need to focus on is how exceptionally great it is that you received a bonus in the first place and how you’re going to invest that money now that you have it!
Can You Reduce Taxes on Your Bonus Check?
It’s important to know that your employer is required to withhold taxes and the IRS will take its cut of any income you receive. Nothing is as certain as death and taxes. Knowing that you can’t avoid paying them, you may wonder if there is any way to reduce the taxes collected. There are three key possibilities to help reduce the tax liability:
- If the bonus is paid at the end of the calendar year you can offset some of the money collected with charitable donations or contributing to your retirement savings account.
- Use the IRS calculator to estimate your withholding eliminating the possibility of too much taxes being withheld.
- Defer your bonus until the following tax year potentially easing the concern that the large sum would thrust you into a higher tax bracket. You still receive the income but in a timely way that allows you to keep more in your pocket over time.
Taxed Bonus and the Life Money Balance
The bottom line is not to be shocked and mystified as to why the government took so much in taxes from the generous gift you were given. You should be proud of the work you did to earn that kind of recognition and grateful for the financial boost. Have a sense of accomplishment and celebrate your being appreciated but investing the extra money in your future and aspirations.
