How are bonuses taxed? Alternative methods and their implications

Who isn’t delighted to receive bonuses? A bonus is an additional amount paid to an employee in addition to the regular salary. It is mostly paid to recognize the performance, but is sometimes also granted as a present before certain festivals or as a means to retain or welcome a staff member.

Based on the organization’s purpose, bonuses can be categorized as Annual Bonus, Signing Bonus, Spot Bonus, Retention Bonus, Holiday Bonus, or Referral Bonus. However, the only downside to receiving bonuses may be how they are taxed.

How are bonuses taxed?

The Internal Revenue Service (IRS) classifies bonus as a Supplemental Income. A Supplemental Income refers to the money an individual earns from side jobs or commissions or bonuses that result in the generation of some extra dollars. This amount is taxed differently from your regular income.

The difference is that bonuses are subject to a higher withholding rate or retention tax than the rest of your income. What leaves many employees not-so-pleasantly surprised is the reduced amount they actually receive after being promised an attractive bonus package. The reason is that employers are required by the government to deduct the withholding tax from these payments before handing them out to employees. As a result, the employees only receive the remaining amount.

There are two methods of calculating the withholding tax on bonuses:

  1. The Percentage Method
  2. The Aggregate Method

Percentage Method

A very straightforward approach to how are bonuses taxed, the Percentage Method requires a flat deduction of a fixed percentage from the bonus amount. For this reason, it is also known as the Flat Rate Method.

Under this method, bonuses are treated as a separate pay-check by employers than the rest of the income. This not only makes it easier for them to calculate the withholding tax, but also usually leaves the beneficiary with a comparatively greater amount in hand.

Currently, the percentage of withholding tax for bonuses and other means of supplemental income in the United States is 22%. However, if the amount of bonus or supplementary wage is above 1 million dollars, the percentage of tax applied would be 37%. Given that 37% is the highest rate of income tax that currently persists, it is very unlikely that an employer would give a bonus that is large enough to fall under that category.

The prevailing bonus rates were set back in 2017 and are expected to remain the same till 2025, at least.

Unfortunately, there are some other deductions that are also made from your bonuses in addition to the withholding tax. They are Social Security Tax and Medicare Tax. These deductions are however not specific to bonuses but also eliminated from all other paychecks.

These are meant for public welfare and an equal amount deducted is contributed by the employer. The total is then paid to the IRS.

The current rate for Social Security Tax is 6.2% whereas that for Medicare Tax is 1.45%.

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Aggregate Method

An alternative way to calculate the tax amount on bonuses is the Aggregate Method. Let’s understand how are bonuses taxed under this approach.

The regular income and bonus are combined together as a single paycheck. The tax is then calculated on the combined amount using the regular income tax rate.

Under this approach, the employee may end up losing more because the amount withheld depends on your tax bracket which will obviously be higher if it considers the accumulated amount.

Even most employers have reported finding this method of calculating tax on bonuses more difficult.

The example mentioned below will help in understanding the above explanation of Aggregate Method.

Example:

Assume your monthly income is $8000. This means that your annual income will amount to $96,000.

8000 ×12 = 96,000

Now imagine that in one of these calendar months, you receive a bonus of around $5000. Your income for that particular month will be $13,000.

8000 + 5000 = 13,000

Under the aggregate method, your employer would multiply 13,000 by 12 that would result in the perception that your annual income is $156,000 instead of $96,000.

Consequently, the withholding tax deducted would be much higher than what you rightfully deserve to pay.

Is there a way to rectify the bonus tax charged from you?

It is very likely that you are overcharged or undercharged depending on how are bonuses taxed at your workplace. However, there is a fix to every problem.

You can determine the amount that you are actually liable to pay when filing your tax return for the succeeding year with the IRS.

If the tax charged from you turns out to be higher than what you needed to pay, you will definitely receive a refund. On the other hand, if it is revealed that a lower amount was withheld from your bonus or supplementary income, you would owe the IRS the outstanding amount.

We hope this detailed explanation of how are bonuses taxed turns out to be helpful for you in the long run, even if you are not expecting a bonus any time soon.

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