Understanding Bonuses and How They Are Taxed
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Like it or not, tax time rolls around every year, and we have to deal with it. Receiving a bonus from your employer can be exciting, but you’ll need to keep in mind that that money will be taxed, just like the rest of your income. Otherwise, it can be very easy to get excited about an anticipated bonus and make plans based on a higher amount than you’ll receive. Here’s what you need to know about how bonuses are taxed and what you can do to hold onto as much of the bonus as possible.
In this article
What are bonuses, and why are they taxed differently?
Some employers give their employees bonuses at different points of the year. Bonuses might be awarded as an end-of-year holiday bonus or at other times to reward a well-done job. Simply put, a bonus is any financial compensation from an employer that exceeds the payment rate that the employer and employee have agreed upon. Bonuses can come in the form of cash or stock options.
According to the Internal Revenue Service (IRS), bonuses are taxable income. This means that employers are required to report any bonus payments to the IRS. The employer must also withhold taxes from the bonus payment when paid to the employee. Since the IRS considers bonuses supplemental income instead of regular wages, they can be subject to different federal withholding rules. Depending on the state where the bonus is paid, it can also be subject to state taxes.
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Types of bonuses
Employees must also report any bonuses they receive when they file their income taxes. You can face penalties and interest charges if you don’t report them to the IRS. All employees should be aware of the types of bonuses they may receive, and be sure to keep track of received bonuses so you can include them as part of your taxable income.
Signing bonuses
Some companies offer signing bonuses to candidates who most want to join their team. This is especially true if the company is trying to hire a candidate who represents the top talent in the industry and if they expect that competitors are pursuing the candidate as well. If the candidate accepts the job, they’ll receive an upfront bonus for joining the company.
Referral bonuses
Current employees may be eligible for referral bonuses if their company hires them for other roles. These bonuses incentivize employees to seek out peers in the industry and recommend the company’s open position to them. If the company hires an employee-recommended candidate, they may receive a referral bonus.
Retention bonuses
If a company is going through a transition period or facing changes in the industry, it may opt to provide a retention bonus to its top employees. Retention bonuses can be given at any time of the year as an incentive to prevent an employee from leaving their position. It can be useful for companies if recruiters and competitors pursue a key employee.
Performance bonuses
Companies might use performance bonuses to encourage and reward employees for hitting certain goals. Typically, performance bonuses are given after the completion of a project. They could also be given at the end of fiscal quarters or key dates within that specific industry.
Holiday bonuses
Holiday bonuses are common at the end of the year. Some companies give them to all employees, while others might only give them to others. Companies may have certain thresholds, such as when they’ve been with the company or who have exceeded performance goals.
Bonuses included in yearly wages
Some companies may offer bonuses as part of an employee’s annual wages. It might be called an annual bonus. If the bonus is part of your yearly wages, it will be taxed at the same tax rate as your regular income.
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Products and services that can help you report your bonuses
Generally, you shouldn’t worry too much about reporting bonuses on your tax return. It should be included on the W-2 that you receive from your employer. However, some products and services can help report all of your income properly on your federal income tax return.
First, you should track all income forms throughout the year. Wages from being a salaried or hourly employee is just the start. You'll have to keep track of those if you receive income from freelance work, investments, rental properties, or running your own business. You should also remember deductions throughout the year, including mortgage interest payments, education costs, childcare costs, and charitable donations.
DIY tax software
Several products today are designed to help you file taxes from the comfort of your home. The costs for these services vary — some are completely free, but others charge a relatively small fee. You also need to be aware that some tax software can handle more complex tax situations, while others can’t support certain tax forms.
If you’re comfortable interpreting and inputting your tax information independently, DIY tax software could be a good option. It all comes down to what you’re comfortable with and your tax situation. DIY tax software can provide a quick and easy way to file taxes online for people with a single salaried position and limited supplemental income sources. Most DIY software can also handle taxes for business owners and self-employed individuals, but this may come at a higher cost.
One of the greatest benefits of using DIY tax software is that they’re often very user-friendly and walk you through the entire process. Most tax prep software asks you multiple-choice questions about your situation, so it can help suggest the product that will be the best fit. If you use the same tax prep software year after year, many of them can also pull your past data (as long as it’s still applicable) to make the process more efficient.
Many tax preparation software also includes certain guarantees. For example, you’ll likely find software that offers the best refund guarantee, which guarantees that the software will input your taxes in a way that will get you the best outcome. If the software makes an error that results in you getting a lower tax return, it may offer you a bonus payment. Most tax prep software also offers assistance with amended returns if you are penalized by the IRS due to a software error. As an additional bonus, some tax prep software offers optional assistance from a tax professional who can answer questions or review your tax return before submitting it.
Working with a tax professional
If filing your own taxes using DIY software feels too daunting, you can always work with a tax professional. Working with a tax professional is especially helpful if you have a more complicated tax situation. This could include having significant assets, various investments, or large charitable donations. A tax professional can help walk you through capital gains tax if you’ve sold any investments. Major life changes such as getting married, having a baby, or buying a house can also impact your taxes, so you might want to work with a tax professional if you’ve experienced one of these changes in the past year.
The cost of bonuses (and how to save as much as you can)
Bonuses can be taxed in a couple of different ways.
- The percentage method is used when a bonus comes in a separate check instead of being included in a regular paycheck. It can also be used for other supplemental wages, such as overtime and severance pay. With this method, a flat rate (22% in most cases) is withheld for taxes. For bonuses that exceed $1 million, the bonus tax rate is 37%.
- The aggregate method is used when a bonus is on the same check as the regular paycheck. When the aggregate method is used, the bonus amount is taxed the same as regular pay. The amount that will be taxed depends on your total income and the federal tax bracket that you’re in.
Paying taxes on your income is necessary for state and federal government programs and services. This is why we pay Medicare tax and Social Security tax. However, you should know that not every “bonus” is taxed. For example, if you receive non-cash bonuses from your employer, this might not be considered taxable income. Common non-cash bonuses include holiday parties, company lunches, event tickets, and so on. Gift cards, though, are considered to be cash bonuses, so those are subject to income taxes.
We all love to receive extra money, but seeing so much of a bonus put toward taxes can be disappointing. While you can’t change that, you can do some financial planning to have a strategy for when you receive a bonus. One way to make the most of your bonus is to increase the contribution to your 401(k) plan. The money you contribute is not taxed at the time of contribution; it’s taxed when you withdraw money from the account. By allocating money from your bonus toward your retirement account, you are saving because it will not be taxed when you receive the bonus. If you have an individual retirement account (IRA), you may also be able to lower your tax bill by contributing some income to this account.
If you itemize deductions, another option is to use some or all of your bonus to increase deductible expenses. Increasing charitable donations is a popular way of doing this. You can also adjust your Form W-4 to change your tax withholding allowances.
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FAQs
What is a withholding rate?
A withholding is the federal income tax amount withheld from an employee’s paycheck. The employer pays the money that is withheld from the paycheck directly to the IRS. The amount that is withheld is based on what is filled out on the W-4 form given to the employer by the employee. This usually occurs when starting a new job, but employees can also request to change their withholding at other times of the year.
The amount of tax that you should have withheld from your paychecks depends on several factors. This includes your filing status and your annual income. The more you withhold from your paycheck, the higher the chances are that you’ll receive a tax refund next year because you’ve already paid more than you owed for that tax year. Some people prefer to do this and look forward to receiving the refund later. Others would rather not have the government holding onto their hard-earned money when they could have received it in their paycheck instead.
To determine how much you should withhold from your paycheck, there are some resources that you can use. One of these is the withholding rate chart, which you should review each year in case changes have been made. If you’ve received a salary increase, you may also want to see if you’ve moved into a higher tax bracket. You can also use a tax calculator and the Tax Withholding Estimator from the IRS to help you make an informed decision.
Related: When Can I Expect My Tax Refund?
If I received a raise at the end of the year, is that considered a bonus?
A raise is an increase in an employee’s regular pay or salary. It is a long-term increase instead of a one-time bonus. Your employer might make decisions about raises and bonuses simultaneously, which may fall at the end of the year. Even so, your raise will not be taxed as a bonus.
How do I know if I received a bonus at work?
If you’ve received a bonus, it will likely be listed on your paycheck. Your employer may also give you a gift card or cash separately from your paycheck. Either way, your employer is responsible for including any bonus payments made to you within the tax year on your W-2.
What is my tax liability?
Every tax filer should be aware of what their tax liability is. Your tax liability is the amount you’ll owe from income, investments, and other assets. The government uses these tax payments to fund necessary services, such as road repairs, assistance programs, and Medicare.
You’ll need a few pieces of information to calculate your tax liability. First, you’ll need to determine how you’re filing your taxes. You can file your taxes as a single filer, a filer who is married but filing separately from their spouse, part of a married couple filing taxes jointly, or as the head of household. This, as well as your income, will determine which tax rate you are liable to pay. You can review tax brackets to find out what your tax rate is. Then, you can use a tax calculator to understand how much you’ll owe over an entire tax year and how different withholding rates can impact that.
The IRS is aware of your tax liability, and when you file your tax return, it will review how much you’ve withheld from your paychecks or paid in estimated taxes already. You would not owe any money if you had enough withheld or made estimated tax payments to satisfy your tax liability. You’ll receive the excess amount as your tax refund if you've overpaid. If you haven’t already contributed enough to meet your tax liability, your tax return will be used to determine how much you’ll need to pay to the IRS and your state.
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The bottom line
If you’re an employee, the idea of a bonus is always exciting. Bonuses are a great way for employers to show their appreciation for employees. Employers also use bonuses to attract top talent or incentivize current employees to stay with the company. However, as nice as bonuses are, they do have strings attached.
Any employee's bonus is subject to income taxes, just as their regular wages are. Fortunately, employers are responsible for reporting bonus payments to the IRS and including them in the W-2s sent to employees for each tax year. There isn’t a lot that employees need to do to ensure that taxes are paid appropriately for bonus payments.
Employees are responsible for keeping track of their income and determining how much they want to be withheld from their paychecks for income taxes. It all comes down to whether you prefer to have more money from your paychecks throughout the year or if you’d rather wait to receive that money in a tax refund. If you decide to have a lower withholding rate, you’ll still need to save up throughout the year to meet your tax liability when you file your income taxes. There’s no escaping paying income taxes on bonuses or other income. However, you can plan and use strategies such as contributing more to your retirement accounts to hold as much of your money as tax-free as possible.
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Ashley Hart is a lead copywriter and digital marketing expert covering finance, law, real estate, music, entertainment, health and wellness.
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