The annual bonus has to be one of the best workplace benefits. After all, you can do plenty of things with a few extra dollars in your pocket that you don’t have to work extra hours for. However, it’s wise not to go on a spending spree until after you figure out how much your bonus tax will be. Unfortunately, the tax treatment for bonuses can be higher than what your employer deducts from your average paycheck. This guide covers how bonuses are taxed and how you might be able to minimize your tax bite.
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How Are Bonuses Taxed?
The IRS defines your bonus earnings as “supplemental income” as this income stream is in addition to your base pay. Some of the other types of supplemental income include:
- Overtime and tips (if paid separately from your regular pay)
- Sick leave
- Vacation pay
- Severance pay
- Back pay
- Awards and prizes
There are two different ways your employer may withhold taxes from your bonus.
The easiest and most common way to pay taxes on a bonus is the percentage method. Your employer can follow these steps to calculate your withholding amount: Regardless of your ordinary tax bracket, the IRS instructs your employer to withhold 22% federal income taxes from any bonus amount under $1 million. The 22% withholding level remains in effect through 2025 when it returns to the usual 25%. State income taxes and FICA taxes (Social Security and Medicare) are also withheld. Your total federal tax percentages are as follows:
- Federal income tax: 22%
- Social Security: 6.2%
- Medicare: 1.45%
That’s 29.65% in federal taxes plus your state tax rate. Your FICA tax withholding may be different if you’re a high-income earner. For example, you pay an additional 0.9% Medicare tax if your annual income is at least $200,000. Also, you won’t pay Social Security taxes on income above the annual base limit. In 2021, the limit is $142,800 and it’s $147,000 for 2022. Check with your state tax agency to estimate your state-level withholdings. If you’re in a lower tax bracket, you may be able to get a tax refund when you file your taxes at the end of the year. See the 2022 federal income tax brackets to estimate your tax liability for this year.
Percentage Method Example
So, assuming you receive a $1,000 bonus, you will pay $220 in federal income tax initially. This formula is simply Bonus amount x .22= federal withholding. As your bonus is subject to FICA taxes, anticipate the total federal tax bill to be $296.50 and extra for state taxes.
The aggregate method is the other way to tax your bonus, and this is the default treatment when your employer lumps your bonus into your recurring paycheck. In a nutshell, your employer withholds tax at your regular rate, just like your base salary. For example, instead of receiving your usual pay of $4,000, it might be $5,000 if you get a $1,000 bonus. Admittedly, this tax treatment is more complex in estimating your taxes. Your employer can follow these steps to calculate your withholding amount:
- Use the tax tables in IRS Publication 15 to estimate the federal withholding on the base pay and also for the bonus
- Withhold the normal amount from the base pay rate
- Withhold the remaining balance from your bonus
Aggregate Method Example
Here is an example involving John Doe, who is married, has a biweekly pay of $3,000, and is getting a $1,000 bonus. The total withholding is $335 for this special $4,000 payment. The standard withholding amount of $213 per pay period applies to the first $3,000, John’s regular pay. Then, payroll deducts the remaining $122 from the $1,000 bonus. Your employer will also withhold FICA payroll taxes and state income taxes.
This calculation method can be time-consuming for a large corporation with many bonus recipients. Your employer may opt for the percentage method because of its simplicity, even if they need to schedule a second direct deposit or cut another check.
You’re also more likely to pay a higher tax rate upfront if you receive a relatively large bonus but can get the difference back with an end-of-year refund. Learn more: IRS Publication 15-T covers the nitty-gritty about supplemental income taxes.
Taxes on Bonuses Larger than $1 Million
If you’re fortunate enough to be receiving bonus payments exceeding $1 million, the tax rules change on the amount larger than seven figures. Under the percentage method, your bonus is either subject to the 22% or 37% federal rate:
- Up to $1 million: 22%
- Above $1 million: 37%
So, if your total bonus amount is $1.5 million, your first million is subject to 22% taxes, and the remaining $500,000 has a 37% tax withholding.
Bonus Tax Exemptions
You must pay income tax on your bonus, but here are some ways you can potentially reduce the tax liability to keep more of your check. It’s worth asking your employer if it’s possible to use one of these strategies.
Request the Percentage Method
If your employee benefits department gives you an option of either tax treatment, consider requesting the percentage method and have them issue a standalone payment. This method withholds a flat 22% from your bonus check and prevents your employer from withholding an incorrect amount. You don’t have to worry about being overtaxed upfront if you’re in the 22% bracket or higher. However, you may get a smaller refund or may have to pay in if your employer didn’t withhold enough from your income during the year. Here are the income ranges for the 22% bracket for the tax year 2022:
- Single: $41,776-$89,075
- Married, Filing Jointly: $83,551-178,150
- Head of Household: $55,901-$89,075
Learn more: Do I need to file a tax return?
Contribute to Tax-Advantaged Accounts
You can consider contributing to these tax-deductible accounts that can reduce your taxable income:
Your bonus can make reaching your annual contribution limits for these various savings and investment accounts easier.
Donate to Charity
If you can file an itemized return, it’s possible to deduct your charitable donations and other qualifying tax deductions like paid mortgage interest, state and local property taxes, and medical bills.
Learn More: How to Get a Bigger Tax Refund
Bonus payments classify as supplemental income, which is any money you earn outside of your regular wages. Your employer may apply the 22% federal tax rate to your bonus income below $1 million. This rate can be different than your regular tax rate which considers your W-4 details.
Your employer reports your bonus income on your year-end W-2 tax form and is part of your gross income for tax purposes. However, your work may withhold a different tax percentage than your regular pay. The tax software will calculate your total tax liability after compiling your taxable income, total withholding, tax deductions, and tax credits when you file your tax return. If you apply for financing, the lender may request that you separate your regular pay from any bonuses or overtime you earn to establish your base annual salary accurately.
Your bonus income reports in Box 1 (Wages, tips, other compensation) of your end-of-year W-2 tax form. This box also includes your regular pay and any additional payments you receive through your employer. Your bonus tax withholdings also populate in the same withheld tax boxes as your regular income.
If your employer withholds too much, you may get some of your bonus tax withholding back with your tax return. However, it’s difficult to estimate how much you may get back until you file your taxes, as you may be eligible for several tax deductions and credits.
Most employers use the percentage method, which taxes your bonus at a flat rate. As a result, the federal withholding is 22% on annual bonuses payments up to $1 million, and the rate increases to 37% for any amount above $1 million. But your first $1 million is only subject to the 22% federal rate. Social Security, Medicare, and state income taxes also apply. So, at least 30% of your bonus goes to taxes, but you might get some of it back as a tax refund.
Your bonus can be an excellent way to get some extra cash that can help save for one of your financial goals or pay off debt. However, you should set aside at least 30% of your windfall for federal and state taxes. After estimating your upfront tax bill, you’re free to start planning how you’re going to use your bonus. So go ahead, enjoy your reward and make the most of the extra cash.