Taxes shrink year-end bonuses
Q: I just got my year-end bonus, and it’s a lot less than I expected because of taxes. Is there any way to avoid taxes on bonuses? A: First and foremost, bonuses are taxed because they are considered taxable income. But the IRS also considers bonuses to be supplemental wages — e.g., overtime and commissions — that aren’t regular wages. When your employer pays supplemental wages, they are supposed to follow payroll tax rules and withhold a portion of those wages (in this case, your bonus) for taxes.
The amount that is withheld from your bonus depends on the withholding method that your employer uses, which depends, in part, on the amount of your bonus and how your bonus is paid.
The first supplemental wage tax withholding method is called the “percentage method.” This method is typically used when your bonus check is issued separately from your normal paycheck.
The percentage method means that if your bonus is less than $1 million, your employer automatically withholds a flat 22% from the bonus for tax. So, if you’ve been told that you are receiving a $5,000 bonus, and your employer uses the flat percentage method, they should withhold at least 22%, which based on this example would be $1,100.
If your bonus exceeds $1 million, the flat percentage withholding would be 37% of the amount of your bonus that exceeds $1 million. Thirty-seven percent correlates to the top federal income tax rate.
The other method for withholding from supplemental wages is the “aggregate method.” This is typically used when your employer pays your bonus money along with your regular pay in a single payment. Under this method, your employer withholds tax in accordance with a formula based on the information that you provided on your W-4 Form.
The aggregate withholding method can cause some confusion and frustration for people. That’s because your regular pay and bonus pay are combined, as a lump sum. As a result, the amount of tax taken out from the check that includes your bonus pay is higher than what you’re used to with your normal paycheck on your regular payday. Keep in mind that other normal income, and payroll, taxes (e.g., state taxes, Social Security taxes, etc.) are also withheld.
Can you avoid paying taxes on a bonus? Because your employer is required to withhold, you can’t avoid the tax on your bonus. But it can understandably be frustrating to receive compensation for a job well done and then find that much of that money goes to taxes.