14 Jun, 2021

How Much Do You Understand Tax On Bonuses?

How Much Do You Understand Tax On Bonuses?
Written by: - Phil Baker

With all the hard work you've put in this year, you deserve all the bonuses that are coming your way. But do you realize how much tax will be taken out of them? Don't panic - you're not the only one wondering what amount of tax on bonuses you'll have to cough up. In fact, taxes can be quite a confusing topic for most people.
If you've received a nice bonus or are due one at the end of the year, you'll want to know exactly how much of it you're pocketing. Bonuses can come already taxed by your employer, or your boss can pay out the whole amount for you to tax yourself later. That's why it's essential to know the ins and outs of tax on bonuses!
We'll go over everything that happens when an employer pays out taxable bonuses, so you can be prepared for whatever bonus you might receive! 

Table of Contents:

  • Types of Tax on Bonuses

    • Federal and State Taxes

      • The Aggregate Method

      • The Percentage Method

      • Tax on Bonuses Over $1 Million

      • Which Method is Best?

    • Social Security Taxes

    • Medicare Taxes

  • Incentive Payments

  • How to Reduce Tax Payments

  • What If Too Much Tax Is Withheld From Your Bonus?

  • Conclusion

Types of Tax on Bonuses

Bonuses are classed as 'supplemental wages', which are basically any pay other than your regular pay. Along with bonuses, things like severance pay, back pay, taxable fringe benefits, overtime, and vacation pay are all classed as supplemental wages, too. Supplemental wages are subject to their own withholding rules and can depend on how your employer chooses to pay you.
Unsurprisingly, there isn't just one general type of tax taken from our bonuses. There are actually three kinds of tax that can be deducted, which explains why so many people find bonus taxing so tricky! Let's take a look at the different types of tax on bonuses to see what yours might be:

Federal and State Taxes

Bonuses are subject to income taxes, but they're not just added to your income and taxed at your top marginal tax rate. As the IRS considers your bonus as supplemental income, its subject to federal withholding.For some, you might also incur extra tax on bonuses depending on the state that you live in. Unfortunately, each state has its own withholding rate, so the amount of taxes you pay may vary.
Currently, only eight states don't charge income taxes, while the others use both flat and progressive tax structures. You may be wondering, 'are bonuses taxed at a higher rate' and sadly, the answer isn't so simple. The federal tax on bonuses is treated differently than the tax on your general income, and it's calculated using two methods:

The Aggregate Method

This method of calculating taxes is more complicated, but it can be a better option for some. The amount of money being withheld is calculated on your regular pay plus your bonus pay - this is based on the information provided on your Form W-4 and IRS withholding tables. Next, the same withholding rate is calculated on your regular income and is then subtracted from the withholding on the total combined amount of regular income and bonus.
The result of this is then withheld from your bonus. Let's go through an example to lessen the confusion: Imagine your regular pay is $1,000, and withholding on that pay is $50. You then receive a tidy bonus of $3,000 from your boss, all in one paycheck. Your employer would then check the IRS wage bracket tables to see how much they need to withhold from the $3,000 - let's say this comes to $300.
Your employer will then subtract your regular withholding ($50) from the $300 you have to pay, leaving you with $250 withheld from your bonus for federal income tax.

The Percentage Method

Using this method, you'll get taxed a flat rate of 22% unless you earn a substantial amount, but we'll talk about that later. Unlike the different tax rate brackets on your general income, this percentage will not change depending on your bonus amount unless you're lucky enough to get bonuses of over $1 million. To make things simple, we'll give you an example of the Percentage Method in action:

If you receive a bonus of $8,000 for the year, you'll have to pay 22% ($1,760) of it, or alternatively, it can be withheld to be sent to the IRS. The 22% rate was implemented in 2017 and is expected to stay until the end of 2025. This means that it will remain as the bonus tax rate for 2020 and 2021.

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Tax on Bonuses Over $1 Million

If you're lucky enough to receive a bonus that exceeds $1 million, you'll have to pay a little more in taxes. For bonuses up to $1 million, you'll still only incur the flat rate of 22% federal withholding tax. However, anything over that $1 million will then be subjected to a 37% tax - or whatever the highest income tax rate is for that year. How about another example:
Let's say you get a $1.5 million bonus. The first million will be taxed at 22%, which shrinks your hard-earned bonus down to $1.28 million already. Then the $500,000 you received over the $1 million limit will be taxed at the highest bracket for that year, taking your bonus to an even lower figure of $1,095,000 - and that's not including any other taxes you might have to pay!

Which Method is Best?

If you're in a tax bracket higher than 22%, the withholding on your bonus will be higher using the aggregate method. However, if you're in a lower bracket, such as the 12% bracket, the aggregate method will be beneficial. Both methods don't apply if your bonus is given to you as one lump sum along with your regular pay.
If this is done, your bonus and regular wage will be subject to withholding as if it was all just your regular pay. You can check your pay stubs to see how your employer pays you your bonuses.

Social Security Taxes

Social Security tax is a type of federal tax used to pay the costs of pensions, widows, and widowers, and disabled individuals. The bonus tax rate for 2020 regarding Social Security is set at 12.4% on any portion of your bonus below the Social Security cap - the cap for Social Security tax for 2020 is $137,700.
Before you start worrying, half of the 12.4% tax rate is paid by your employer (unless you're self-employed), so you'll only have to pay 6.2% on your bonus. The Social Security maximum taxable income for 2020 is $137,700, while the new taxable income rate for 2021 is $142,800.

Medicare Taxes

Like Social Security benefits, Medicare's Hospital Insurance Program is funded mainly by taxes we pay. Unlike Social Security taxes, Medicare taxes don't have a maximum taxable income. However, there is an additional Medicare tax for single taxpayers with substantially high incomes - we'll get to this further on.
The medicare withholding rate is currently 1.45% of your pay, which also includes your bonuses. This percentage isn't halved between your employer and yourself; instead, the percentage is paid in full by both of you. Additional Medicare tax rates are currently set at 0.9% for single filers who earned over $200,000 or $250,000 for married couples who file jointly. So, for those earning over $200,000, you’ll have to pay 2.35% Medicare taxes (1.45% + 0.9%).
Employers will withhold the additional Medicare tax as soon as you start to earn over $200,000. For Additional Medicare tax, your employer doesn't have to contribute.

Incentive Payments

For those that get incentive payments rather than bonuses, things are slightly different. Incentive payments aren't considered to be regular income that gets reported on Form W-2, so they're subject to different rules when it comes to taxes. These payments will be reported on the 1099-MISC form as "other income," rather than on Form W-2 with other wages and payments from which taxes are withheld.
As a general rule, incentive rewards are given to employees to thank them for specific achievements. These rewards can be cash, merchandise, or even travel. Incentive rewards, no matter what form they come in, are taxable as ordinary income. So while income tax isn't withheld from incentive payments, they will be included with your taxable income when you prepare your tax return.
Depending on the incentive reward you receive, you might have to pay taxes. You don't have to pay taxes on incentive awards such as:

  • Holiday gifts

  • Occasional transportation fare, snacks and meals, and tickets for entertainment events

  • Group-term life insurance for spouse or dependent, face value can't exceed $2,000

  • Special occasion gifts such as flowers, books, fruit, etc.

  • Achievement awards that don't fit on the taxable categories listed below

If your employer has rewarded you with one of the following incentives, you'll have to pay some taxes:

  • Cash benefits like a bonus

  • Gift certificates that can be redeemed for merchandise or exchanged for cash

  • Achievement awards that are cash or equivalent, vacation, meals, lodging, theater or sports tickets, or securities - these are classed as awards rather than gifts.

How To Reduce Tax Payments

Now, don't get your hopes up - you can't avoid paying your taxes, and you can't reduce them entirely. However, there are a few ways you can reduce how much you own in taxes. All it takes is a bit of know-how! Using your bonus funds to invest in your 401(k) or IRA can be a wise and completely legal way of reducing your tax on bonuses.
Alternatively, if you're expecting a pay cut in the next year (this could be a reduction of hours or retiring), you could ask your employer to defer your bonus until the following tax year. This way, you'll still receive your bonus; however, you won't be charged as much tax - you just have to wait a little longer to receive your money.

What If Too Much Tax Is Withheld From Your Bonus?

Are you worried that too much tax might be taken from your bonuses? Well, it is possible for you to be over-taxed, although it's easily resolvable if you know what you're doing! If you prepare your tax return and notice that your withheld bonus amount is way too much based on your end-of-year tax rate on your taxable income, you should receive a refund.
The IRS will work out how much tax you have paid, and if it's above the flat rate of 22% of your overall income, you'll get issued a refund. Want to know how the IRS checks your tax is correct? They'll check your Form 1040 tax return, as this will show an overpayment of taxes if you have indeed been paying too much.
The IRS will then refund any difference between the balance you paid in over the year and what your tax return determined that you should have paid.

Conclusion

If you want to avoid paying hefty taxes on your bonus, it's important that you understand everything there is to know about the applicable taxes. As we mentioned before, a lot of people fall victim to these high taxes because they don't take the time or effort necessary to understand how things work. But you do! If taxes are your downfall, or you just want to learn more about what they are and how they work, we can help with that too!
You can find some incredibly helpful tax information online with a bit of research, like this guide to tax preparation. Now that you understand how bonus taxing works from top to bottom (and all in between), you'll be able to make better-informed decisions on whether taking a bonus will have any negative consequences - you just need to put this newfound knowledge into action! in addition, stay abreast of the tax refund chart!
So now you can sit back and relax, knowing that hidden taxes won't pick-pocket your well-deserved bonuses. Need a paystub? Fill in one of these templates and let's get you started!

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