One approach to thank employees for a job well done is to give them a bonus. However, while bonuses are fantastic for employee appreciation, they come with a catch: they have their own set of tax restrictions. Because bonuses are taxed differently than regular wages, it’s critical to understand the correct tax calculations to ensure you’re withholding the correct amounts.
What is a Bonus?
A bonus is a type of compensation given to a worker at the discretion of the firm. Bonuses are typically lump sum payments made in addition to a worker’s regular income or earnings.
Most bonuses are given out on special occasions (for example, a holiday) or are built into specific compensation schemes (for example, meeting a quarterly sales goal). Other forms of bonuses include yearly, merit, referral, sign-on, and retention.
Different Types of Bonuses
According to the Department of Labor, bonuses are classified as either discretionary or nondiscretionary. Income taxes apply to both types.
#1. Discretionary Bonuses
Discretionary bonuses, as the name implies, are often paid at the employer’s discretion. This means they are not paid at the employee’s regular rate and must meet the following criteria:
- The company has the option of awarding the incentive to the employee.
- The company can determine when to give the employee the bonus.
- The bonus is not given in response to a prior contractual agreement or promise that would have led the employee to expect a financial payout.
Discretionary bonuses include end-of-month bonuses and severance money.
#2. Non-discretionary Bonuses
Nondiscretionary bonuses are determined by company norms. This indicates that the employee is aware of the requirements for receiving a bonus. Nondiscretionary bonuses are usually included in the employee’s base salary.
Here are some examples of nondiscretionary bonuses that an employee may receive:
- Following the achievement of individual or group productivity targets
- In exchange for maintaining a specific level of attendance
- For excellent and precise work
- Following a specified amount of days without a safety event
Are Employee Bonuses Taxed?
Employee bonuses are, in fact, taxable income. Employee bonuses are considered another form of employee income by federal and state tax authorities, and as with ordinary salaries, any bonuses you provide your employees are taxed. However, because bonuses are classified as supplemental compensation by the IRS, they are taxed differently than normal pay.
What is the Bonus Tax Rate?
The rate of bonus taxation is 22%. If you pay employee bonuses of more than $1 million, the first million dollars are taxed at 22%, and anything above that is taxed at 37%.
These values only apply to the federal bonus tax rate; you must withhold additional federal and state taxes on bonuses. [Use online payroll software to ensure that you are withholding the correct taxes from your bonuses.
How are Bonuses Taxed?
Your employer must deduct money from your bonus check in the same way that it deducts money from your regular salary to prepay your taxes. The IRS receives this cash on your behalf. This is referred to as tax withholding.
Employers can compute your tax withholding on bonuses in one of two ways: the percentage method or the aggregate method.
#1. The Percentage Method
The percentage technique, often known as the flat rate method, is the simplest way for employers to calculate bonus taxes. It frequently results in extra money in your pocket, at least at first.
When an employer taxes your bonus using the percentage method, the incentive must be identified as distinct from your regular salary. The percentage of withholding for supplemental wages is 22%. During the tax year, that rate will be applied to any supplemental wages, such as bonuses, up to $1 million. If your bonus exceeds $1 million, the withholding percentage for any sum over $1 million rises to 37%.
Examples of the percentage method
The % technique is demonstrated in two cases below.
Example 1:
The bonus sum is $10,000.
$10,000 x 22% = $2,200 in federal income taxes withheld
Bonus balance: $7,800
Example 2:
The bonus sum is $1.5 million.
$1 million x 22% federal tax equals $220,000 $500,000 X 37% = $185,000Federal income taxes of $220,000 + $185,000 = $405,000 withheld
Bonus balance: $1,095,000
Note: If your supplemental pay exceeds $1 million in a calendar year, your employer must use the flat rate technique and calculate your bonus withholdings (over $1 million) at 37%.
#2. The Aggregate Method
Employers may offer bonuses in addition to normal salary. In this case, your employer must calculate the initial tax withholding on your bonus using the aggregate approach.
The tax withholding on your bonus is determined using the aggregate approach at your regular income tax rate. Your tax bracket determines your withholding rate. When taxes on earnings and bonuses are calculated in this manner, your initial tax withholding is frequently larger.
Example of the Aggregate Method
Assume your monthly payment is $6,000 on average. Your tax withholding would be based on a $72,000 yearly salary ($6,000 X 12). That income puts you in the 22 percent federal tax bracket (assuming you file as a single or head of household).
Continuing with this example, suppose your employer pays you a $10,000 bonus one month. The employer includes it in your normal $6,000 income but labels it as a bonus. Your monthly income increases to $16,000 during the current month.
Your employer would multiply $16,000 by 12 months using the aggregate method. This would result in the tax withholding on your bonus being computed as though you earned $192,000 per year, putting you in the 32% tax bracket. The employer would deduct the taxes already deducted from your last paycheck and deduct the remaining amount from your bonus.
Exemptions From The Regulations
The IRS will take a percentage of any bonus you earn. Even if you receive your bonus in the form of cash, gift cards, a trip, or any other perk, you will almost always be required to pay taxes.
The only exception is if your bonus qualifies as an employee achievement reward. Under the following situations, you may be eligible to avoid paying federal income taxes:
- The award is not in cash, but rather in a cash equivalent (such as a gift card or money order). Tickets to events, trips, stocks, bonds, and other banned commodities are all prohibited.
- The reward is a piece of tangible personal property.
- The total prize amount does not exceed $1,600.
Why are Bonuses So Heavily Taxed?
Bonuses are heavily taxed since they are considered “supplemental income.” Although all of your earned dollars are equal at tax time, the IRS considers bonuses to be supplemental income and requires a higher withholding rate.
You’re undoubtedly noticing withholding on a reduced bonus check.
How to Reduce the Tax Implications of a Bonus
#1. Examine your W-4
Because bonuses can happen at any time of year, they are added to your income piecemeal. This can cause your profits to rise or even push a portion of your income into a new tax bracket, increasing your tax liability.
It may be worthwhile to change your withholdings on your W-4 form before or after your bonus is handed out. Calculating how much to withhold might be difficult, but our W-4 calculator can help you understand if you’re on track to owe, receive a refund, or have your tax due zeroed out. A little tinkering can go a long way toward avoiding a tax payment.
#2. Confirm that your bonus is taxable.
Make certain that the bonus you’re receiving is, in fact, a bonus. The IRS provides guidelines for determining what bonuses are taxed. Tickets to events, Christmas gifts, money for meals while working extra, flowers, books, and other infrequent low-value fringe benefits are often nontaxable.
However, when your employer gives you cash, a gift card, or a high-value gift, things become murkier. If you have any questions concerning the tax implications of a gift or award, consult with a tax specialist.
#3. Tax Deductions
Tax deductions are one of the most well-known methods of lowering your taxable income and offsetting some of your tax liability. Most taxpayers use the standard deduction, but if your individual tax-deductible expenses, such as unreimbursed medical expenses, charitable contributions, or mortgage interest, exceed the standard deduction, itemizing can help you reduce your taxable income and save money on your tax bill.
#4. Make a tax-advantaged contribution
As far as tax-cutting tactics go, this one appears to be a win-win for the majority of people.
Consider using your bonus to make a qualifying contribution to a tax-advantaged plan, such as your 401(k), HSA, or traditional IRA, if you haven’t already done so. Because the money you put into these accounts is pre-tax, it can reduce your taxable income while simultaneously contributing to a long-term savings objective.
#5. Postpone your bonus
Some persons may also request that their bonus be deferred until the next year. Importantly, doing so does not reduce the taxes owing; rather, it simply delays payment until a later date. This technique may make sense if: you believe your bonuses will cause a portion of your income to be taxed at a higher rate, and you need more time to pay for the taxes you may due.
You believe your total income will be smaller next year than it is this year, lowering your tax liability.
Because this can be a tough technique to handle, speak with a tax professional to ensure it’s the best choice for your financial situation.
Is it Possible to Avoid Paying Taxes on a Bonus?
You cannot avoid paying taxes on your bonus because your company is compelled to withhold. However, it is obviously aggravating to get compensated for a job well done only to discover that a large portion of the money goes to taxes.
With that stated, if you’re wondering how your bonus payout will affect your taxes, the IRS has a calculator that can help you estimate your withholding before you file your tax return. And, if you file your federal income tax return and discover that too much tax was withheld (based on your income and tax rate), you may be eligible for a tax refund.
If, on the other hand, you’re concerned that your bonus will be significant enough to push you into a higher tax band, you could consider delaying it to the next tax year.
For example, if your firm intends to pay your bonus in December and you anticipate having less income the following year, you may be entitled to request that the bonus payment be deferred.
If you receive your bonus at the end of the year, you may be able to offset it and other taxable income with certain year-end tax moves. Tax deductions for charitable contributions and contributions to a retirement savings account can occasionally reduce your tax liability.But keep in mind that the deadline for making many of the significant contributions for tax purposes that could assist offset a year-end bonus is December 31.
Where Do You Begin With Bonus Tax Reporting?
Although a monetary bonus may be subject to different withholding rules, it must still be reported on your W-2.
If your company reports your bonus on a 1099-MISC, you should immediately request a cancellation and a revised W-2; if your employer refuses to offer a correction, you can still report your bonus correctly for tax purposes. On line 1 of your Form 1040, submit the wages stated on the 1099-MISC, and include Form 8919 to report any uncollected Social Security and Medicare taxes.
Conclusion
If you were informed you would receive a year-end bonus for your work in 2023, don’t be startled if it appears in your bank account as a reduced sum in the coming days or weeks. Bonuses are subject to taxation because they are considered earned income. But congrats; any extra cash in a savings account is useful in this high-interest-rate era.
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