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Interactive by Column Five

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These questions are explored below:

Bonuses Are Considered “Supplemental Wages”

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

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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

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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

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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.

First, even though this is bonus money, it is still considered taxable income by the IRS. You will need to pay federal income taxes on this money.

How Taxes on Bonuses Get Withheld

If your employer pays you the bonus through their regular payroll system, they should handle the tax withholding as they normally do. But don’t be surprised to see taxes of 25% withheld from this bonus money. Why? IRS guidelines typically require taxes of 25% to be withheld from income that is considered a supplemental wage. Bonus money is usually considered supplemental.

Keep in mind that just because 25% is withheld, you might not owe that much on this money. The IRS just requires it upfront via the withholding. You may get a percentage of it back when you file your return next April.

If your employer pays you with cash or in some way outside of their normal payroll system (e.g. hefty gift card), this isn’t an invitation to become a tax evader. You should simply report this bonus as income on Line 7 of your Form 1040. With that in mind, make sure you set aside some of the bonus for taxes.

Tax-Deferred Automatic Contributions and Bonuses

If you have money being automatically contributed to a 401(k), health savings account, or other tax-advantaged savings vehicle, then be careful with bonuses. Your employer will likely continue to contribute to these accounts with the bonus payout using the original contribution percentage that you set up. So if you already automatically contribute 5% of your gross income to your 401(k), your employer will probably take 5% of your bonus money and put it in your 401(k). If you are not careful, you could exceed your annual maximum allowable tax-deductible contributions to your 401(k). Most employers should be tracking this information for you, but some may not. Check into it.

Reduce Your Current Year Taxes with Bonus Money

If you spend your bonus on the right things, you could end up getting a tax savings equal to the taxes that you have to pay on the bonus income. Here are some tax-advantaged ways to use your bonus money:

• More Retirement Savings – Use your bonus money for additional retirement plan contributions. You could do this through your 401(k) or 403(b) at work. Just make sure you get the money into your account prior to the end of the year. If you don’t have an employer plan, you could make a traditional IRA contribution. With an IRA you have until the date you file your taxes to make the initial contribution.

• Green Home Improvements – Does your home need upgrading? Energy-efficient home improvements will provide you with a tax credit of up to $1,500 or 30% of the cost of the improvements. Qualifying improvements include things like adding insulation, replacing windows, and adding energy-efficient doors.

• Give it Away – If you were fortunate enough to get a bonus this year, you may desire to share some of that bonus with those people or organizations in need. Giving money to a qualifying charitable organization will provide you with a tax deduction as long as you itemize deductions on your return.

• Make Pre-Payments – If you have a mortgage, consider making your January mortgage payment in December. This will add to the amount of mortgage interest you paid in the year. Like charitable contributions, mortgage interest is deductible if you itemize. You should also consider making your property tax payments prior to year end, as this will give you another deduction.

Congratulations again on your holiday bonus. Have fun spending it wisely!