Last Updated: February 2, 2023
Bonuses are taxed differently than regular salaries. While bonuses play a role in keeping employees satisfied, they can also present challenges. Just as income is taxable, bonuses are treated as income and are, therefore, subject to taxation, as well. But just how are bonuses taxed? This article addresses these unique tax rules and tips on how to manage your bonus checks.
Bonuses as Supplemental Wages
There are several types of bonuses that represent a performance reward of an employee—the most common of which include mid-year and end-of-year bonuses. These are distributed as additional payments beyond a regular salary.
The International Revenue Service (IRS) regards bonuses as supplemental wages, i.e., income paid by the employer in addition to regular wages. These IRS supplemental wages are subject to different withholding rules.
|NOTE: Bonuses need to be 10% higher or more than the annual salary of an employee to motivate them to higher performance.|
How Are Bonuses Taxed?
An employer holds a certain percentage of the employees’ regular paycheck for federal taxes, as well as supplemental wages. Taxes in the US are managed by the IRS, who consider bonuses the same as income—so federal taxes must be paid on them. This process is known as tax withholding.
So how are bonuses taxed? There are two methods: the percentage method and the aggregate method.
This arrangement is the simplest way to calculate withholding on supplemental wages. Taxing a bonus using this method requires a separate paycheck for regular wages and one for bonus checks. Supplemental incomes are subject to a flat 22% federal withholding rate. If the bonus exceeds $1 million, it’s subject to a 37% federal withholding rate.
There might also be additional tax liabilities, such as Social Security or Medicare. As of 2020, the Social Security tax was at a 6.2% rate and the Medicare tax was 1.45%.
The bonus amount an employee receives should be multiplied by 22%—the result is the withholding tax, e.g., if you receive a bonus of $8,000, $1,760 would be withheld for federal taxes. On a larger scale, when you multiply $1 million by 37%, you have $37,000 withheld in federal taxes.
This option of taxing a bonus is more complicated than the percentage method. If an employee’s monthly salary, for example, is $7,800 and receives an annual bonus of $10,000, the latter is added to $7,800, resulting in $1,700 a month. If 24% is withheld in income taxes, then the withholding of the bonus amount would also be 24%—using the aggregate method means that $25,872 would be the resulting bonus withholdings.
Instead of working with an accountant, you can consider using appropriate online tax filing software. We’ve compiled a list of the best ones—you can check it out here.
|NOTE: The average taxpayer spends around 11 hours in record-keeping, tax calculating, and other activities related to taxes.|
Even if a bonus is distributed as extra cash or as a cash gift, you still need to pay taxes on it. But if the bonus is regarded as an achievement award, you are not required to pay taxes on it—that is if the achievement award is not over $1,600 and is not a cash bonus but rather a non-monetary gift.
Non-monetary gifts are non-cash gifts, intended for use in the form in which they are given, e.g., tickets to a theater or sporting event, decorative gifts. This category of gifting is also known as de minimis fringe benefit (‘minimal’ benefit).
|Companies generally distribute annual bonuses and mid-year bonuses.|
|Bonuses are subject to a 22% flat rate with the percentage method.|
|With the aggregate method, bonuses are calculated as part of a monthly salary.|
|If bonuses are regarded as an achievement award, they are not subject to taxes.|
Avoiding Taxes on Bonus Checks
Earned income is taxable, and bonuses are no exception. But many would like to know how to avoid taxes on a bonus check. There’s no absolute way of avoiding taxes on bonus checks, but there are several strategies that can help when it comes to managing such taxes. The first move you might want to consider is to reduce your gross income and increase the deductions that apply to your income.
Pay Medical Expenses
Pay unreimbursed medical expenses. You can significantly increase deductions and reduce your taxable income by paying these off with bonus checks. Be aware, however, that you can only pay for medical expenses if the unreimbursed medical expenses are at least 10% of your adjusted gross income.
Requesting Non-Financial Bonuses
The ability to work from home can be viewed as a non-financial bonus. Many during the pandemic started working from home, converting their households into a home office space. But not every non-financial bonus is tax-free. There are several exceptions where taxes are paid with non-financial bonuses, e.g., receiving extra paid vacation time instead of a check.
A great way of how to avoid taxes on a bonus check is to deduce your gross income by making a retirement contribution—also known as a bonus sacrifice because an employee can sacrifice their bonus by putting it into a pension fund rather than a bank account. They, then, can save money by not paying federal income taxes.
|NOTE: According to a survey taken in September 2020, two out of three top PEO companies will award an annual bonus in 2021, which will keep the bonus poll almost the same as in 2020.|
A Bonus Tax Refund?
There are many questions about whether we can receive a bonus tax refund. If more money is withheld than what was accounted for, you should probably get a bonus tax refund. But this depends on your tax situation. The aggregate method calculates the supplemental wages tax together with a regular salary, which leads to a lower bonus payment. In this case, you’ll need to wait until it’s time for you to file your tax return so the overpayment can be refunded. When it comes to the percentage method, the IRS will issue a refund for the money withheld from your bonus if it turns out that the 22% was over-withheld based on your overall income.
You should always be aware of the ins and outs of how to tax a bonus, including how the percentage and aggregate methods work. There are several instances where bonuses can be tax-free. This article has aimed to help you understand how employee bonuses and taxes work.
Bonuses are regarded as supplemental income. Even though all of your money is withheld at the same tax rate, bonuses are withheld at 22% or more, depending on the method your employer uses to calculate the withholding on supplemental wages.
Bonuses are not taxed at a different tax rate than regular salary. There could be some confusion in understanding the withholding process because bonuses are withheld at a separate flat rate from regular salary. But when you file your W-2 form, you’ll notice that they are reported and taxed the same.
This is a similar question to: how are bonuses taxed? If you click on the link, how to do taxes on your own, you’ll be redirected to a page where you can calculate the supplemental wages tax rate.