Everyone appreciates being recognized for their work, and it can be especially gratifying when that recognition comes in the form of a bonus. Unfortunately, the Internal Revenue Service (IRS) will have its hand out for some of that cash. Your bonus will most likely take a bit of a hit in the form of tax withholding at the time you receive it.
The good news is that you might get a portion of that money back when you file your tax return. It’s no different from over-withholding from your paychecks during the course of the year. The IRS will issue you a refund for any excess.
Bonuses Are Supplemental Wages
The IRS classifies bonuses as “supplemental wages,” along with severance pay, taxable fringe benefits, vacation pay, back pay, and overtime. Supplemental pay is pretty much anything other than your regular pay, and it’s subject to its own withholding rules. These rules depend to some extent on how your employer pays you the money.
Bonuses might be subject to their own withholding rules, but they’re treated just like your other ordinary income at tax time when you file your return. They’re included in your taxable income—what’s left after you claim the various deductions and credits you’re entitled to—and tax brackets and their applicable rates are based on that income.
How Are Bonuses Taxed?
Your employer has two options when it comes to calculating how much to withhold: the percentage method or the aggregate method. The percentage method is a flat 22%. No other percentage can be used.
These two methods are used to calculate federal tax. Your bonus and any other supplemental wages you receive are subject to Social Security, Medicare, and FUTA taxes.
The Percentage Method
Your employer can simply withhold the flat 22% that’s applicable to all supplemental wages under $1 million. This rate was put in place after 2017 and is expected to be in effect until the end of 2025, which means it’s applicable for tax year 2020 (which you file in 2021), as well as tax year 2021 (which you file in 2022). The IRS refers to this option as the “percentage method.” So, for example, if you receive a bonus of $3,000, this would result in a withholding of $660.
This rate applies even if your regular wages fall into a tax bracket that’s greater or less than 22%.
The Aggregate Method
This option is more complicated, as the name suggests. Withholding based on the aggregate method is first calculated on your regular pay plus your bonus pay, based on the information you provided to your employer on your Form W-4 and the IRS withholding tables.
Now, the same rate of withholding is calculated on just your regular income. This figure is then subtracted from the withholding on the total combined amount of regular income and bonus, and the result is then withheld from your bonus.
Let’s say your regular pay is $1,000 and withholding on that pay is $50. Your employer then gives you a $3,000 bonus, all in one paycheck. It works out like this:
You're now subject to $300 withholding on the total combined wage and bonus income of $4,000. Your employer would subtract your regular withholding of $50 from that $300 and would then withhold the balance of $250 from your $3,000 bonus.
The aggregate and percentage method calculations apply only to federal income tax. The usual withholding rates for Social Security and Medicare also apply to bonuses, as well as any state or local income tax you might be subject to.
Tax Treatment of Huge Bonuses
Now let’s assume that your employer thinks so insanely high of you that they and the company decide to give you a $1.5 million bonus.
The first $1 million is subject to the 22% withholding rate that applies to bonuses and supplemental wages paid in the 2020 tax year. Just like that, your bonus shrinks to $1.28 million because $220,000 goes to the IRS right off the top. The $500,000 you received over $1 million is subject to withholding at the rate of the highest tax bracket for that year: 37%. That’s another $185,000 that goes directly to the IRS.
Your total withholding on that $1.5 million works out to $405,000: $220,000 at the 22% rate, plus $185,000 at the 37% rate, leaving you with $1,095,000.
Are There Exceptions to These Tax Rules?
These methods don't apply when you receive your bonus lumped together with your regular pay, all in one check, and your employer doesn’t specifically make note that the bonus amount is separate and apart from your regular pay. The total—your bonus plus regular wages—is subject to withholding just as though it was all your regular pay in this case.
Otherwise, your employer must use either the percentage method or the aggregate method to calculate withholding.
Incentive Payments Are Different
Incentive payments aren’t considered to be regular income reported on Form W-2 so they’re subject to different rules. They're reported in Box 3 on the 1099-MISC form as "other income," not on Form W-2 with other wages and payments from which taxes are withheld.
These payments are most common in the auto industry when the auto manufacturer—not the dealership—issues a monetary award to salespersons.
Income tax isn’t withheld from incentive payments, although they’ll be included with your taxable income when you prepare your tax return. You don't have to pay Social Security or Medicare taxes on incentive payments, either.
Which Method of Tax Withholding on Bonuses Is Best?
Generally speaking, the percentage method is a lot easier. As for which benefits you—the employee—the most, it might come down to your tax bracket.
The withholding on your bonus is going to be more using the aggregate method if you’re in a tax bracket that is higher than 22%, such as the 24% or 32% bracket. It's something of a wash if you're in the 22% bracket. And if you’re in the 12% bracket? Ask your employer to use the aggregate method.
What If Too Much Tax Is Withheld From Your Bonus?
So let’s say that you prepare your tax return and it turns out that what was withheld from your bonus was way too much based on your end-of-year tax rate on your taxable income. The IRS will issue you a refund for the money withheld from your bonus if it turns out the 22% rate was too much based on your overall income at year’s end.
Your Form 1040 tax return would show an overpayment of taxes, just as it would if you overpaid through withholding from your regular wages. The IRS refunds any difference between the balance you paid in over the year and what your tax return determines that you actually owe.
Frequently Asked Questions (FAQs)
Can you avoid tax on a bonus?
You can reduce your tax liability on a bonus by putting it toward deductible expenses or other tax-sheltered uses. These include charitable donations, contributions to a 401(k) or traditional IRA, health savings account contributions, and certain medical expenses. If your normal tax rate is lower than 22%, ask your employer to include the bonus in your regular pay instead of as a separate payment.