Whether it’s expected or unanticipated, receiving some extra cash and recognition from your employer in the form of a bonus is always appreciated. But it’s important to remember that, as with all income, the IRS will want its fair share of your windfall, which means the amount you’re told you will receive will almost certainly never match the actual amount that ends up in your pocket.
Further complicating the matter is that a bonus is considered to be a form of “supplemental wages,” which means it's subject to its own tax withholding rules. So it’s understandable if you’re not entirely sure how bonuses are taxed. Here’s what you need to know.
What are supplemental wages?
Supplemental wages are any form of payment that you receive as an employee other than your normal salary or wage. In addition to bonuses, this category includes overtime, tips, commissions, accumulated sick time, prizes or other awards.
Why does this matter? Because supplemental wages are subject to their own tax withholding rules that are different from other forms of income.
Tax withholding for your bonus
Supplemental wages, including your bonus, can be taxed in two different ways. One is a flat percentage, the other is a percentage that changes based on the amount of your pay and bonus. Here’s how each works:
The percentage method
If your employer pays you your bonus separately from your regular pay, then it will employ the percentage method.
This means that it will simply withhold the flat rate as required by the IRS. As mentioned above, this would be 22 percent for most people receiving a bonus (and 37 percent for any amount above $1 million). This means that if you receive:
- A bonus that is up to $1 million, your employer must withhold 22 percent of your bonus for federal income taxes.
- A bonus above $1 million, your employer must withhold 22 percent on the first million, and then 37 percent on anything above that first million, for federal income taxes.
This flat withholding rate is the source of a lot of confusion. After all, if your marginal tax rate is normally lower than 22 percent, then it may seem that you are actually paying additional tax on your bonus.
But when you file your taxes at the end of the year, your bonus is ultimately treated just like the rest of your income. That means that if you receive a bonus and still fall into a tax bracket that is lower than 22 percent, you’ll receive a refund equal to the excess amount that was withheld.
However, if it turns out that you fall into a higher tax bracket, you’ll have to make up the difference between the 22 percent that was withheld and your final tax rate.
The aggregate method
If your employer pays you your bonus in the same check as your regular pay, then it will employ the aggregate method. This is much more complicated compared to the percentage method, as it requires your employer to consider both your regular wages and your bonus.
This method is a little more confusing because of the way federal taxes work. Basically, as you earn more, you pay additional income tax. With the aggregate method, your company adds the amount of your bonus and base pay. It then assumes you’ll get that higher amount all year and withholds based on that amount.
For example, if you normally earn $4,000 per month, or $48,000 per year, this would place you in the 22 percent tax bracket.
If you were to receive a $10,000 bonus one month and your employer uses the aggregate method to determine your withholdings, they would:
- Add the $10,000 bonus to your $4,000 base pay ($14,000)
- Multiply this number by 12 months ($168,000)
- Find the tax bracket for this new amount (34 percent)
- Subtract from this amount any taxes already withheld from your paycheck
The remainder would then be withheld from your bonus.
In addition to the federal tax rate mentioned above, it’s important to remember that your bonus will be subject to other taxes as well. This includes state income taxes (if your state levies one), Social Security and Medicare taxes.
Lowering your tax burden
While the IRS is going to get its fair share of your bonus, you may be able to employ certain strategies to lower your tax burden.
If you’ve already received a bonus or anticipate receiving one and are unsure how the bonus will impact your tax burden for the year, a tax professional can help you understand your options. In addition to helping you lower your tax burden by deploying some of the strategies outlined above, they can also help you put your bonus to good use as you work toward your financial goals.
Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.