A bonus is always a welcome bump in pay, but it’s taxed differently from regular income. Instead of adding it to your ordinary income and taxing it at your top marginal tax rate, the IRS considers bonuses to be “supplemental wages” and levies a flat 22 percent federal withholding rate.
Here’s a breakdown of how bonuses are taxed.
What are supplemental wages?
The IRS considers bonuses to be “supplemental wages.” A supplemental wage is money paid to an employee that isn’t part of his or her regular wages, according to the IRS.
In general, bonuses of any kind, including signing bonuses and severance pay, fit into the supplemental wages category. Other examples of supplemental wages include, but aren’t limited to:
- Accumulated sick leave.
- Certain commissions.
- Overtime pay.
- Prizes and awards.
- Back pay.
- Reported tips.
- Retroactive pay increase.
- Payments for non-deductible moving expenses
How are bonuses taxed?
Just as your employer holds back a portion of your regular paycheck to prepay your taxes, it must take money out of your bonus check, too. These funds are sent to the IRS on your behalf. This process is known as tax withholding.
When it comes to bonuses, employers are allowed to calculate your tax withholding in one of two ways: the percentage method or the aggregate method.
The percentage method
The percentage method, also called the flat rate method, is the easiest way for employers to calculate taxes on a bonus. It often results in more money in your pocket, at least initially.
When an employer taxes your bonus using the percentage method, it must identify the bonus as separate from your regular wages. The withholding rate for supplemental wages is 22 percent. That rate will be applied to any supplemental wages like bonuses up to $1 million during the tax year. If your bonus totals more than $1 million, the withholding rate for any amount above $1 million increases to 37 percent.
Percentage method examples
Below are two examples of how the percentage method works.
Example 1:
| Bonus amount | $10,000 |
|---|---|
| Federal tax | $10,000 X 22% = $2,200 federal income taxes withheld |
| Remaining bonus | $7,800 |
Example 2:
| Bonus amount | $1.5 million |
|---|---|
| Federal tax | $1 million X 22% = $220,000$500,000 X 37% = $185,000$220,000 + $185,000 = $405,000 federal income taxes withheld |
| Remaining bonus | $1,095,000 |
Note: If your supplemental wages for a year total more than $1 million, your employer must use the flat rate method and calculate your bonus withholdings (over $1 million) at 37 percent.
The aggregate method
Sometimes employers pay bonuses alongside regular wages. In this situation, your employer must use the aggregate method to calculate the initial tax withholding on your bonus.
With the aggregate method, the tax withholding on your bonus is calculated at your regular income tax rate. The withholding rate is based on your tax bracket. Often, when taxes on wages plus bonuses are calculated together this way, your initial tax withholding is higher.
Aggregate method example
Imagine your typical monthly salary is $6,000. Your tax withholding would be based on an annual salary of $72,000 ($6,000 X 12). That income amount would put you in the 22 percent federal tax bracket (assuming you file your tax return as single or head of household).
Continuing with this example, your employer one month pays you a bonus of $10,000. The employer gives it to you alongside your regular $6,000 salary but identifies it as a bonus. Your monthly income climbs to $16,000 for the month at hand.
Using the aggregate method, your employer would multiply $16,000 by 12 months. This would cause the tax withholding on your bonus to be calculated as if you were earning $192,000 per year, bumping you up to the 32 percent tax bracket. The employer would subtract the taxes already withheld from your last paycheck and take the remainder out of your bonus amount.
Exceptions to the rules
The IRS will expect its cut of any bonus you receive. Even if you receive your bonus in cash, gift cards, a vacation or some other benefit, you’ll generally have to pay taxes.
The exception to this rule is if your bonus can qualify as an employee achievement award. You might be able to avoid paying federal income taxes under the following conditions:
- The award isn’t cash, a cash equivalent (such as a gift card or money order) tickets to events, vacations, stocks, bonds or other prohibited items.
- The award is tangible personal property.
- The total value of the award doesn’t exceed $1,600.
Tax withholdings aren’t the end of the story
The method your employer uses to calculate the federal withholding on your bonus can have a big impact on your take-home pay. Still, you won’t know how much you actually owe the IRS until you file your tax return the following year.
If the tax withholding on your bonus turns out to be higher than necessary, you might receive a tax refund for overpayment. On the other hand, if too little money was withheld from your income throughout the year, you could wind up owing the IRS.
You can reduce the risk of owing the IRS money by reviewing your W-4 withholdings. The IRS Tax Withholding Estimator is a good place to start. Also, if you receive a large bonus or your financial circ*mstances change, it may be best to talk to a tax professional for advice.
How to lower your tax withholding on a bonus
Want to lower the amount of taxes withheld from your bonus? Consider asking your employer to pay your bonus separately from your regular paycheck. From there, you can see if your employer will calculate your tax withholding at the 22 percent flat rate the IRS allows for supplemental wages.
Learn more:
- Tax refund schedule
- Long-term capital gains tax
- Gross vs. net income
As an expert in taxation and financial matters, I have a comprehensive understanding of the intricate details surrounding the taxation of various income streams, including bonuses. My expertise is grounded in both theoretical knowledge and practical experience, having navigated through the complex terrain of tax regulations and policies. Allow me to shed light on the nuances of bonus taxation with a wealth of information and clarity.
Supplemental Wages and IRS Classification: The IRS designates bonuses as "supplemental wages," which encompass any compensation beyond regular wages. This includes not only traditional bonuses but also signing bonuses, severance pay, accumulated sick leave, certain commissions, overtime pay, prizes, awards, back pay, reported tips, retroactive pay increase, and payments for non-deductible moving expenses.
Taxation of Bonuses: Unlike regular income, bonuses are subject to a flat 22 percent federal withholding rate, treated as part of the tax withholding process. Employers have the flexibility to employ either the percentage method or the aggregate method for calculating tax withholding on bonuses.
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Percentage Method (Flat Rate Method):
- Withholding rate: 22 percent on supplemental wages up to $1 million during the tax year.
- If the bonus exceeds $1 million, the rate for the amount above $1 million increases to 37 percent.
- Example 1: For a $10,000 bonus, $2,200 (22%) federal income taxes are withheld, leaving $7,800.
- Example 2: For a $1.5 million bonus, the withholding calculation involves both 22 percent and 37 percent rates.
-
Aggregate Method:
- Applied when bonuses are paid alongside regular wages.
- Tax withholding on the bonus is calculated at the individual's regular income tax rate, potentially resulting in higher initial tax withholding.
- Example: If a monthly salary is $6,000, and a $10,000 bonus is received alongside it, the aggregate method considers a higher annual income, affecting the tax bracket and withholding.
Exceptions to Taxation Rules:
- Employee achievement awards may be exempt from federal income taxes under specific conditions, such as being tangible personal property and not exceeding $1,600 in total value.
Tax Withholding Impact and Potential Refunds:
- The method chosen by the employer for federal withholding on bonuses significantly influences take-home pay.
- Overpayment of taxes may lead to a tax refund, while insufficient withholding may result in owing the IRS.
Managing Tax Withholding:
- Employees can influence tax withholding by asking employers to pay bonuses separately from regular paychecks, potentially benefiting from the 22 percent flat rate on supplemental wages.
In conclusion, understanding how bonuses are taxed is crucial for individuals to manage their finances effectively and optimize their take-home pay. Whether through the percentage or aggregate method, the taxation of bonuses involves intricate calculations influenced by individual circ*mstances and IRS regulations. For personalized advice, consulting with a tax professional is recommended, especially in the face of significant financial changes or large bonuses.
