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

Income and Investments

Employers love supplementing wage and salary income with bonuses. It’s an excellent way to reward top performers and motivate employees to do more than the bare minimum. 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”

Bonus Taxes
Bonus Taxes

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.

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.

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.

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 35% 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!

Why Does It Seem Like Bonuses Get Taxed More?

Employees often complain that their bonus checks have seemingly been taxed at much higher rates than their ordinary income. Yet, as The Street shows us by way of example, this is actually an illusion:

“If you make $2,500 a month but get a $5,000 midyear bonus, your withholding will be computed as if you received a single wage payment of $7,500 for the monthly payroll period. Then that $7,500 is annualized, or assumed to be part of your yearly salary. So if you earned $7,500 a month, you’d be making $90,000 annually versus $30,000. But at $90,000, your tax rate jumps to the 31% tax bracket vs. the 28%.

Under this annualized method, you would end up taking home even less of your bonus because you’d be withheld at much higher rates.”

What happened here is that your employer used the aggregate method to calculate your bonus withholdings instead of the simpler and smaller percentage method. The IRS didn’t apply a higher rate – your higher tax payment is simply a byproduct of the withholding method your employer chose.

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

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.

Comments (149) Leave your comment

  1. If it’s true that bonuses are taxed the same as income in the end (and I think that’s true), this article is extremely misleading in the way it confuses withholding rates with actual tax rates.

  2. if my employer withholds my bonus taxes using the aggregation method, would i be entitled to a refund at tax time of the difference between the aggregation method and the percentage method? (i.e. if a bonus is taxed at 40% using the aggregation method can i get a 15% refund (the difference between the 40% (aggregation method) and the 25% (percentage method))?

  3. I work at a car dealer and my employer is taxing my commission as a bonus! Is this right? I earn a commission as a % of sales but they list it as a bonus on my paystub which results in a flat 25% tax.

  4. My employer taxes my vacation check as a luxury taxes at 28 percent 2400 and I received 1400 why do they tax it like that.and how do I stop them from doing this they take the luxury out of my vacation. Please help

  5. My employer gives me a w2 for taxs withheld and when I get a bonus they give me a 1099 for the bonus my CPA tells me this is not right if anybody knows the law on this please help me understand

    1. I do not think that is right for you to get a 1099 for your bonus, unless it was not taxed at all. It should be wages (supplemental) but still wages.

    2. Your CPA is correct. Your employer is treating your bonus like a sub-contractor’s labor payment. He is avoiding the taxes he should pay (FICA) on the bonus by doing this. This also transfers the tax burden to you in the way of having to now pay the FICA for both the employer and your share. And to add insult to injury, you could be charged a self employment tax on what is essentially being reported as self employment income. The IRS could charge the employer for misclassifying labor wages and fine the employer. I’ve seen upwards of $40,000 in fines for a hospital who practiced this same policy. Additionally, when you file your taxes, your W-2 and the 1099 will have the same EIN from that employer. That’s a huge red flag for you and the employer to be audited. I would urge the employer to stop this practice.

    3. Your CPA is right. You’re an employee, so all wages paid should be treated like wages, including bonuses. It sounds like they don’t know the rules or they are trying to work around the rules.

  6. This information was very useful. It offered a clear explanation as to why my $200 incentive bonuses end up as $129 deposits.

  7. Does the Flat Tax withholding of 25% include Unemployment and Medicare? if not, i think this would be a good point to mention.

  8. I live in New york city so I have Federal, state and NY city taxes taken from my check. Is the 25% only for Federal taxes? I also have 401k taken out at 3%. The gross was 2481.61. The pay out was almost half. Does this sound correct? It looks like an awful amount taken for taxes.

  9. This article is very misleading and incorrectly refers to taxes and “tax impact” of bonuses.

    Bonuses, like all supplemental wages, are TAXED EXACTLY THE SAME as all other income — only the temporary WITHHOLDING is different. After your personal tax return is filed and any refund is received, the employee receives the EXACT SAME amount of money from the bonus that they would have if it were regular pay.

    The author should post a correction.

    1. Thanks for spelling that out. I was trying to get this question answered to decide on how I should allocate a portion of my bonus for pre-tax 401k. Since only the withholding and not the *actual* tax is different, it doesn’t make a difference from a tax perspective whether I contribute bonus dollars or salary dollars. IOW I can just focus on deciding how I want to time my contributions & what level of take-home I want each month.

      The idea that bonus is taxed differently is pervasive but I just couldn’t believe what people were telling me.

    2. Please put a note on the article explaining this is only about withholding and not about actual tax you pay when you file. It’s a good article that explains why one gets higher withholding on bonus payouts but does not put at ease by saying if that’s more than normal you would get back extra withholding while you file your returns.

    3. Hi Bill,

      I recently received a commission check from my employer, and it appears that it was taxed with the aggregate method (paid in conjunction with a pay check). assuming everything else with my income/deductions remains the same, does it stand to reason that I’ll receive a larger than usual tax return next year, to account for the larger withholdings from this one check?

  10. How do I handle a bonus I received (untaxed) from a prior employer? I received a retro bonus in the amount of $ 65000 with nothing withheld.

    1. If I’d seen this sooner, I would have advised to send in an estimated tax payment to the IRS but the deadline for estimated tax payments for the previous calendar year would have been January 15th. Hope you got an answer sooner than now.

  11. I mostly use PDFfiller, Inc. to fill out my tax documents online. It’s not the same thing, but maybe someone needs it. It also allows you to erase in a pdf and esign.
    It’s pretty easy to use and it’s pretty cheap. I think you can get a free week if you and a friend both register.

    1. Depends on your employer. Having gone through something very similar at the end of the tax year, my payout was up to what I would have made for this calendar year, and the remainder deferred to the following calendar year. In the eyes of the IRS, I won’t be making double my salary for one year.

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