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

Income and Investments stocksy_txpaf998130yp7100_medium_200752_720

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?

Comments (154) Leave your comment

  1. Does anyone know if a retirement payment made directly from your former employer is considered supplemental wages? Mine is considering it supplemental and causing me to way over with hold.

  2. My salary is biweekly and is $150,000 per year. Last year my bonus was $330,000. My employer taxed my bonus as salary…as if I make $330,000 biweekly. My $330,000 bonus was taxed at an inflated rate and my net pay for my $330,000 bonus was $120,000. How can I prevent this from happening again? I work for a large company, but the ladies in payroll do not like change. I would like to net more from my bonus pay in 2016 because I anticipate an expensive(my deductible is$15,000 because my income is high) surgery. I know some of you reading my comment think that I am a Fat Cat. I don’t feel rich. I live in California, pay a 13 CA state income tax, probably about 30 percent to Fed, FICA with employer contribution is 12 percent Medicare tax and My income bracket is stuck with Obama care tax, prop tax is $12,000, CA sales tax is 8 percent and on and on and on. Thank you for reading my comment.

    1. This same thing just happened to me (but with a MUCH SMALLER bonus). The gross amount was $350.00 and the net was about $207.53. I knew something was wrong because I’ve worked there for 4 years and the net amount was never such a small percentage. I talked to our payroll mgr & she said it’s because we switched payroll companies and most of them including ours (Ultipro) treats bonuses as regular twice-monthly salary instead of a once-monthly bonus and each have a different tax structure. I and others expressed our extreme disappointment since it wasn’t like this with ADP, and our payroll mgr told us that is because it was altered in ADP by our former payroll manager (it’s legal). Sooo, long story short – she changed settings in Ultipro so they tax our bonuses at the monthly instead of the twice-monthly rate since our bonuses are only paid once monthly. Going forward, our bonuses will be taxed at a better rate!! I encourage you to ask your payroll dept if they can make an adjustment.

    2. Hi! Diana,

      This morning I was having this discussion with my wife, thus leading me to a search on google. I too am seeking the best possible way to optimize her deductions, since I’m a stay at home dad and the lack of an income can make things pretty tough at times and so far here’s what i have:

      1. Maximizing your 401k right before the bonus period. In fact you could meet the contribution limit just from that one check.

      2. If your employer provides max out your HSA (Health Savings Account) around $6800 annual/family. Unlike a flex spending account, you dont loose what your you dont use and what you dont use will grow (based on fund selection) and can be used to pay medical bills tax free. Use of non medical needs will incur a 20% penalty.

      Not a whole lot of savings but based on what I’ve looked into is all I can suggest…

  3. 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.

  4. 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))?

      1. Agreed, you will. This article fails to mention this even though it is one of the most common questions. If so a lot of your income is from a bonus and it is taxed at the aggregation method, you will get a good sized refund to even this out.

  5. 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.

  6. 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

  7. 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.

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

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

  10. 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.

  11. 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?

  12. 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.

  13. 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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