Bonuses are an excellent way to motivate employees and reward top performers. Yet, bonuses can quickly change one’s tax return depending on the size of the payout, the pertinent IRS guidelines, and how employers choose to handle it. 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. There are two ways of taxing bonuses: 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 when your employer adds the amount of your bonus (say, $5,000) to 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 being taxed at a flat 25%, and having that 25% rate apply only to the bonus amount, you get taxed 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 for the same amount of income.
Here is a free bonus calculator based on the aggregate method. Use it to determine your bonus-related tax obligation should your employer choose this approach. 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. Of course, as discussed above, employers are not limited to the percentage method. They can, at their discretion, use the aggregate method for the bonus 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!
Are you lucky enough to get a bonus? Which tax method will your employer use?