Everybody loves an annual bonus at the end of the year, but not everyone understands how bonuses affect their tax returns or even what the Internal Revenue Service (IRS) considers a bonus.
Let’s address some common questions about annual bonuses and what you should expect if you receive one this year.
At a glance:
- The IRS considers bonuses to be supplemental income and taxes them at a flat withholding rate of 22% (a higher rate applies to bonuses over $1 million).
- Your employer can tax your bonus in one of two ways — the percentage method or the aggregate method.
1. What counts as a bonus for tax purposes?
According to the IRS, a bonus is any payment made from an employer to an employee in addition to regular wages.
It can be cash or non-cash. A holiday bonus is taxable, even if it is presented as a gift.
However, if you receive a small non-cash holiday gift from your employer, such as a ham or popcorn tin, you don’t have to claim it as a bonus. The IRS specifically excludes such “de minimus fringe benefits” from taxation.
2. Why does my employer withhold more from my bonus than my regular pay?
If you’ve received an annual bonus from your employer in the past, you might have been surprised by a smaller amount than you were expecting. Because of this, you might have even wondered if your employer correctly calculated the withholding tax.
Just like overtime pay, the IRS considers bonuses to be supplemental income — basically, income that is separate from your regular pay. Supplemental wages are taxed differently, and your employer must use an IRS-approved method to determine how much tax should be withheld. Your employer can use one of the following methods:
- The percentage method: Many employers choose the percentage method for its simplicity. Using this method, your employer withholds a flat 22% federal income tax rate from your bonus pay (assuming it’s under $1 million), regardless of your tax bracket. Any amount over $1 million gets hit with a bonus tax rate of 37%, and your employer has to use the percentage method if your bonus exceeds $1 million.
- The aggregate method: Using this method, your employer adds your annual bonus with your regular income in one lump sum, and you’ll have taxes withheld at your normal rate, depending on your tax bracket.
Neither method is perfect, and you should always double-check your withholding for the year if you receive an annual bonus so you know what to expect at tax time. If your employer doesn’t withhold enough, you may find yourself with a tax bill. If they withhold too much, you’ll get the excess back as a tax refund.
3. Are bonuses subject to payroll taxes?
Yes, you and your employer must pay payroll taxes on bonuses, just as you do with your regular pay.
4. Could my employer have made a mistake?
Mistakes can happen. Even companies that use payroll software or services can accidentally enter the wrong information.
Most of the time, however, the tax withholding on bonuses is calculated according to IRS rules. If you have questions about the amount withheld from your bonus, the best first step is to talk to your payroll department.
5. I’m sure they withheld more tax than necessary. What can I do?
Assuming your employer calculated the bonus withholding correctly, you cannot get the withheld tax back from the IRS until you file next year’s tax return.
An easy way to even out the amount you have withheld is to file a new Form W-4. Adjusting your withholdings can reduce the amount of tax withheld from your pay for the rest of the year. Be sure to file another Form W-4 next year or whenever you need to adjust it again.
6. Is there a way to minimize taxes on my bonus?
One way to minimize the taxation of your bonus is to claim tax deductions, which reduce your taxable income. Claiming tax deductions can help you offset some of your tax liability and ultimately lead to less of your bonus amount being taxed.
7. Can getting a bonus check bump me into a higher tax bracket?
It’s possible that a bonus or a pay increase can put you in a higher tax bracket. That means you will pay a higher tax rate on each additional dollar you earn.
Some people think they may actually have less after-tax income because of a bonus, but this is not true. Being in a higher tax bracket does not change the rate you pay on everything you earn — only the rate you pay on taxable income that exceeds a certain amount.
So, even if your annual bonus bumps you into a higher tax bracket, don’t worry — you’ll still come out ahead!
The bottom line
Annual bonuses are a welcome reward, but understanding how they impact your taxes can help you avoid surprises come tax time. Whether your employer uses the percentage method or aggregate method, and whether your bonus is big or small, the key is to plan ahead. Double-check your tax withholdings, explore deductions to offset tax liability, and remember: even if a bonus pushes you into a higher tax bracket, you’re still earning more overall. By staying informed, you can enjoy your well-earned bonus without any tax-related stress.