If your employer offers an annual bonus, or if you’ve earned one for exemplary work, you may have gotten excited at the amount and already started making plans for how to spend it all. Then your paycheck arrives and your bonus is much less than you thought. Taxes can take a big chunk out of your bonus. Here’s how taxes are calculated on your bonus—and what you can do to get some of that money back.
The Bonus Tax Rate
Bonuses, surprisingly, are not taxed like ordinary income. Instead, they are taxed at the supplementary income tax rate, which is a flat 22%. This may be more or less than what you would usually pay. However, if the bonus is more than $1 million, the tax rate increases abruptly to 37%.
What counts as supplementary income? Almost anything that isn’t part of your usual salary or wage might be included, such as:
- Signing bonus
- Severance pay
- Overtime pay
- Some commissions
- Tips
- Back pay
So, if you’re expecting money from any of these sources, keep in mind the amount you actually receive may be less. Your employer will use the W-4 you have filled out for them in order to work out the proper deductions.
Methods of Calculating Taxes
While the amount you owe is very simple, what your employer should withhold can be more complicated. There are two methods they may use to calculate it.
First, the percentage method involves separating out your bonus from your other pay and calculating taxes on it. So if you receive a bonus of $100,000, they can multiply by .22 and withhold $22,000. You would receive the remaining $78,000. Or, if you receive a bonus of over $1 million, they will calculate 22% on the first million and 37% on the remainder.
However, they are also permitted to use the aggregate method. In this method, they add your bonus to your regular monthly paycheck. So, if you normally make $4,000 a month, you make $48,000 annually, giving you a top tax bracket of 22%, assuming you’re a single filer. But if you receive an extra $10,000 in January, your monthly income jumps to $14,000. Your employer can then multiply that number by 12—as if you earned that amount every month!—and calculate your annual income as $168,000. That means they can deduct taxes at 24%, even though that isn’t the actual amount you will eventually owe, unless you receive a bonus like that every month of the year. This extra withholding will only happen the month you receive the bonus.
How is that fair? Well, the bright side is, it’s only temporary. If you don’t end up getting a bonus like that every month, don’t worry—you should receive a refund on the extra when you file. But if you’re expecting a bonus, you can ask your employer to separate the bonus from your regular paycheck to make sure you’re only taxed at the supplemental income rate.
How to Reduce Taxes on Your Bonus
In the above scenario, although too many taxes were withheld, the actual tax situation wasn’t far from a normal year in the end. But what about when you receive an unusually large bonus that actually does bump you into a higher bracket?
In some cases, employers pay end-of-year bonuses that would be handier for you if they came in the following year. For instance, if you plan to get married or are expecting a child, getting that money in January would mean you owe less on it. However, your employer likely wants to write off that money this year, not next. Bonuses can be a way for them to clear out excess cash at the end of the year. All you can do is ask about delaying it and see what they say.
Other than that, all you can do is pull out all the tax reducing tricks you know. For instance, you can contribute much of that money to your traditional retirement fund. That can give you a big boost on your savings goals, plus you won’t owe taxes on the money until you withdraw it. Another option is to make a large charitable donation. After all, if you haven’t relied on that money as usual income, it may be easier to part with it. You might also prepay on your mortgage or property tax and deduct some of that.
How Is Your Tax Planning?
Bonuses can mess with a normal budget by making you pay more in taxes than you usually do. A tax professional or financial advisor may be able to help you find ways to reduce some of the tax burden. But remember—they can help you much more if you talk to them during the year. By the time they’re preparing your taxes next year, the tax year is over and you can’t do as much. To find a professional who can help you plan for the future, contact us today.
