The Tax Implications of Receiving a Holiday Bonus

The holidays are a time to give and receive. If you are lucky enough to be receiving a nice company bonus this year, let me be the first to congratulate you. Your hard work has paid off. But since you were awarded a bonus, there are a few things you should know with regard to your taxes.

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!