Bonus Time: How Bonuses Are Taxed and Treated by the IRS

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Bonuses are an excellent way to motivate employees and reward top performers. Yet, bonuses can quickly change one’s tax return and the amount of taxes initially withheld depending on the payout. Are bonuses treated as regular income or singled out for special tax treatment? Are some types of bonuses more favorable than others? And are there any ways to minimize the tax impact of getting a bonus?

These questions are explored below:

Bonuses Are Considered “Supplemental Wages”

If you read the tax code, you will notice that the Internal Revenue Service goes to great lengths to categorize different types of income and treat them differently. Bonuses are another example of this. In the eyes of the IRS, bonuses are typically categorized as “supplemental wages.” As a University of Minnesota summary explains:

“The IRS defines supplemental wages as compensation paid in addition to the employee’s regular wages that includes, but is not limited to, severance or dismissal pay, vacation pay, back pay, bonuses, moving expenses, overtime, taxable fringe benefits, and commissions.”

As such, bonuses (like other supplemental wages) are treated differently than ordinary wage or salary income when it comes taxes withheld at payout. There are two ways of withholding taxes from your bonus: the percentage method and the aggregate method. Which method gets applied to your bonus? Let’s find out.

1. The Percentage Method

The IRS specifies a flat “supplemental rate” of 25%, meaning that any supplemental wages (including bonuses) should be taxed in that amount. If you receive a $5,000 bonus, under this rule, $1,250 (25% of $5,000) goes straight to the IRS. Using this approach, the amount of your bonus, whatever it is, is “singled out” from the rest of your income and taxed directly. Employers frequently choose the percentage method because it’s easy and mindless to tax the entire bonus at a uniform rate. In most cases, this is ideal from your standpoint as the bonus receiver and taxpayer, too. The aggregate method (described below), in addition to being more time-consuming and laborious for employers, can take a bigger tax bite out of your bonus payments.

2. The Aggregate Method

Unlike the much simpler percentage method, the aggregate method is used when your employer pays your bonus (say, $5,000) with your most recent regular paycheck. Then, they determine the normal withholding amount based on IRS withholding tables for the sum of both amounts, subtract what was already withheld from your last paycheck, and withhold the rest from the bonus amount.

The problem with this approach is that instead of taxes being withheld at a flat 25%, and having that 25% rate apply only to the bonus amount, taxes are withheld at what is almost certainly a higher rate on the combined amount of your normal pay and the bonus. The result: a higher overall tax obligation initially for the same amount of income.

Check out our free bonus calculator that answers one of our most frequently asked questions and get an estimate of how much federal taxes will be withheld from your bonuses when you receive them.

Tax Tip: If your bonus puts you in a higher tax bracket this year, and you expect to make less next year, see if your employer can defer your bonus to lower your tax bill this year.

Bonuses Exceeding $1 Million

What about high-end corporate bonuses, like those exceeding $1 million or more? These are singled out for higher taxes. If you receive a bonus of more than $1 million, your employer must withhold 39.6% of the amount above $1 million, as well as the standard 25% of the amount below $1 million.

In short: If you dislike the eye-popping bonuses top executives receive, you can take comfort in knowing how large a bite the IRS takes!

No matter what method is used to witthhold taxes from your bonus at payout, don’t panic.  Remember, taxes may be withheld at a higher tax rate at payout, but when you file your taxes at tax time your actual tax rate is based on your total taxable income, which may be lower.  Depending on your taxable income, actual tax rate, and eligible tax deductions and credits you may get some of the money withheld back in the form of a tax refund.

Are you lucky enough to get a bonus?  Which tax method will your employer use?