Calculate Tax on Bonus Payments
Employers give bonuses to employees for various reasons. Perhaps it’s a one-time reward for a job well done. Or it may be a payment made at regular intervals, based on company performance. Whatever the reason, bonuses are considered supplemental income by the IRS. As such, they are subject to special withholding rules.Your employer has options, both as to the method of paying your bonus, and how to calculate withholding. Which options are chosen can have an impact on how much of your bonus you’ll actually take home.
Determining How Your Bonus Will Be Paid
- Contact your payroll or accounting department to see what method they use to pay bonuses. Find out if your bonus will be a separate payment, or if it will be lumped together with your regular paycheck. Don’t make the mistake of thinking “money is money, so how I get it doesn’t really matter". There could be a big tax difference between your employer including your bonus with your regular wages in a single payment, or giving you a separate check.
- The difference is because a one-time bonus of $3,000 added to your paycheck of, say, $35,000 could throw you into a different tax bracket, making the amount of income tax you owe higher. A single person in the US who makes $35,000 a year is currently in the 15% tax bracket, but an income of $38,000 a year (which the bonus would take you to) would kick you up to the 25% bracket.
- Learn how your employer calculates withholding tax on bonuses. Basically, under IRS rules, companies have three options in calculating taxes on bonuses. The first two listed immediately below apply where the bonus is paid to you separately from your regular pay. The third is applicable when the employer gives you your bonus and regular pay in one payment. (Again, payroll or accounting should have the answer for you.)
- Option 1 - The “percentage” method. This is where a flat rate is applied to your bonus amount. A "flat tax" of 25% on bonuses is pretty common.
- Option 2 - The “aggregate” method. Here, the employer combines your regular income and your bonus, but uses a formula to calculate the tax on each separately.
- Option 3 - The “single payment” method. Your bonus and regular wages are combined, taxed together, and paid together.
- Find out if your employer offers the option of letting you choose the payment and/or tax calculation method. In a large company, this may not be possible, since the business probably wants consistency in how bonuses are paid out. But a small employer may not be concerned with the payment method or tax calculation method used. This could work to your advantage once you determine the possible tax consequences of how your employer pays, and calculates the tax on, your bonus.
Calculating the Tax
- Calculate your tax using Option 1- the percentage method. Under this method, your employer applies a flat tax rate of 25% to the bonus amount. That amount is then withheld from your bonus for federal taxes. For example, let’s assume you had a bonus of $5000. Your employer would withhold a straight $1250 (25%) from this amount. This is separate and apart from your regular paycheck, which would remain the same as usual.
- Compute the tax using Option 2 - the aggregate method. Here your employer adds the amount of your bonus to the amount of your most recent regular paycheck. Let’s say that your regular gross paycheck is $2000, and your bonus is $5000, for a combined total of $7000. Let’s also assume that the normal withholding from your regular pay is $500. In computing the tax on your bonus, the employer would:
- Determine the withholding amount (based on IRS withholding tables) for the $7000 total. For our example, we’ll use a figure of $2100 as the total withholding amount on the $7000.
- Subtract the $500 normally withheld from your paycheck from the $2100 (total tax due on the $7k). The remaining $1600 will be deducted from your bonus check.
- Apply Option 3 - the single payment method. Like the aggregate method, in this scenario the employer lumps your regular pay and bonus together. Going back to our example, this would amount to $7000. The company then uses the standard IRS withholding tables to calculate the tax based on this combined figure. Again using our example, this results in a withholding amount of $2100. However, the employer doesn’t give you your regular paycheck plus a separate bonus check. Rather, you get one paycheck for the $7000 less the total withholding of $2100.
- Remember to factor in Social Security, Medicare, and state withholding. Bonuses, as supplemental income, are subject to Social Security and Medicare withholding. Additionally, your state may have its own tax rate for supplemental income. You’ll have to take these into account in figuring out the total tax on your bonus. Supplemental tax rates, on a state-by-state basis, can be found here.
- Use a tax calculator. Many financial sites offer free tax calculators. Using this tool can facilitate determining the tax liability that would be incurred under the three tax calculation options relating to bonuses.
Reducing Your Tax Liability
- Speak with your employer about which tax payment method and calculation method to use. If your employer gives you the option of choosing the tax payment and/or calculation method, ask to have your bonus paid using the method that you calculated puts the most money in your pocket.
- Ask your employer to defer your bonus until the beginning of the new year. Many times employers like to pay holiday bonuses in December, because they're able to write them off if they close their yearly books on December 31st. If you feel it would be more beneficial to you to have your bonus paid in the following year, see if there’s any leeway in the company’s policy. This would be ideal if you expect to have more deductions the next year, such as if you’re buying a house.
- Deferring doesn't always reduce your tax liability. In most cases, it's just moving from one tax period to the next. If next year's income and taxes will not be lower, there's usually no advantage to deferring.
- Use your bonus money for additional retirement plan contributions. This is another good way to reduce the tax liability resulting from a bonus. You could do this through your 401(k) or 403(b) at work. If you don't have an employer plan, you could make a traditional IRA contribution.
- Pre-pay your mortgage and property taxes. If you have a mortgage, consider making your January mortgage payment, and paying your next property tax bill, in December. This will give you additional deductions for the current tax year.
- Consider other means of reducing tax liability. The steps listed above are only a few of the ways your tax liability can be diminished. Some others you might want to consider are:
- Make “green” home improvements. Residential energy-efficient home improvements (like solar water heaters and solar panels) may provide you with a tax credit of up to 30 percent of the cost of the improvements.
- Earn tax-free income. Some income or benefits may not be subject to income tax, thus lowering your tax liability. Consider investing in tax-exempt bonds, depositing money in a tuition plan for your child's education, or opening a health savings account. Tax-free income sources may still trigger alternative minimum tax in some cases, so it's smart to consult with a tax accountant for advice.
- Look into a child-care reimbursement account. If your employer offers one, use it. You'll be paying your child-care bills—but with pre-tax dollars. Let's say you have $5000 in child care expenses per year. You’d probably have to earn about $7500 to net that $5000, because of the taxes on that income. With a child-care reimbursement account, you avoid both income and Social Security taxes.
- Take an eligible home office deduction. The IRS has loosened eligibility rules for claiming a home office deduction. Whether you work from home for your employer, or operate a side-business, you may qualify. You can check here to find the IRS rules that apply to home office use.
- See other wikiHow articles, including Save Money on Taxes and Pay Less in Taxes, for more tips.
- Bonuses are taxed differently for hedge fund and other investment managers. Investment managers often take their bonuses from investment gains, and these can be taxed at the long-term capital gains rate, which is usually significantly lower than standard income tax rates.
- In using the percentage method of tax calculations, the 25% rate applies to the first $1 million of a bonus. For any amount above $1 million, a 35% flat rate will be applied.
- With the aggregate and single-payment methods of tax calculation for bonuses, you may be taxed at a higher rate than usually applies to you, because the tax is being calculated on your normal pay plus your bonus. Depending on the size of your bonus, this may bump you up to a higher bracket in the IRS withholding tables. The good news, relatively speaking, is that if this leads to an overpayment of your taxes for the year, you’ll be entitled to a refund when you file your tax return.
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