For tax purposes, a salary increase is generally better because it's taxed as regular income at your actual marginal tax rate, avoiding the higher flat-rate withholding (often 22%) applied to bonuses, which can make bonuses feel like they're taxed much higher initially, even though the final tax bill is often the same when you file your return, as bonuses are just supplemental income. The key difference is withholding, not final tax liability; a raise gradually increases your base pay, while a bonus is withheld at a higher flat rate (the Percentage Method), making it seem like you lose more upfront, but you'll get it back as a refund if you overpaid.
Because your bonus increases the total amount for that pay period, it might temporarily move you into a higher tax bracket — meaning more tax is withheld upfront. However, this doesn't necessarily increase your total tax bill for the year; your final tax liability is determined when you file your return.
Generally speaking, an increase in salary will usually be the better option in the long term, as your salary level factors into all of your future pay rises (and possibly even future bonuses, if yours are based on a percentage of your salary).
You can't entirely avoid taxes on a bonus, but you can significantly lower the amount by contributing to tax-advantaged accounts (401(k), IRA, HSA), deferring the bonus to a year you expect to be in a lower tax bracket, or making charitable donations, thereby reducing your taxable income or increasing deductions at tax time.
Bonuses under $1 million are typically taxed at a flat rate of 22%. Example: If you receive a bonus of $20,000, the flat federal tax rate of 22% would amount to $4,400. If you receive a bonus above $1 million, you'd pay the 22% rate on the first million. Beyond that, the rate jumps to 37%.
Before you start making plans to spend it, it's important to understand how that income will get taxed. Yes, your bonus money is taxable—typically 22% is withheld for taxes—and it's up to you to make sure the appropriate amount gets paid.
Why is tax withholding on bonuses so high? Since bonuses are paid in addition to your normal paycheck, taxes are withheld at a higher rate than your regular wages. This is because they are considered supplemental income.
Yes, it is true you are allowed to change your W-4 to ensure less withholdings on your bonus pay. However, the ramifications of such a change may be unknown until tax filing time. Generally, it is better to leave your W-4 alone and have the extra withholdings.
Bonus contributed pre-tax to super
For example, tax on a $50,000 bonus: Paid to you and your marginal tax rate is 32.5% = $16,250. Paid to you and your marginal tax rate is 37% = $18,500.
Employee Satisfaction Can Be Negatively Impacted
Bonuses can push employees to work harder and improve their work ethic. This pressure can become too much and they give up as their goal is out of reach, which drastically decreases their job satisfaction and productivity.
The 9.6% average is a good bonus percentage benchmark, but it isn't one-size-fits-all. You should shift this percentage based on industry factors and what's feasible for your company.
Duration of compensation
One of the most notable differences between bonuses and raises is the duration of the compensation. Bonuses are one-time, short-term financial rewards. A raise is an increase to your current salary for the foreseeable future and provides more long-term benefits.
The amount of income tax due depends on which income tax bracket the employee falls into, but it also needs to be borne in mind that bonus payments can push an employee's total annual income into a higher tax bracket.
Key takeaways
Employers generally withhold taxes on bonuses at a 22% rate, with anything over $1 million withheld at 37%. This is called the percentage method. Alternatively, employers can combine the bonus with your regular pay and withhold tax on the entire sum.
Request a Non-Financial Bonus
You may be able to reduce taxes on your bonus to zero by asking your employer to make it a non-financial bonus. Examples of non-financial bonuses could include the ability to work from home or work flexible hours. Not all non-financial bonuses are tax-free, however.
The benefits of bonus sacrifice
The main benefit of paying your bonus into your pension is tax relief. If you take your bonus as cash, this will be subject to income tax, National Insurance contributions and maybe other deductions (such as student loans).
Remember to submit a new W-4 form with your regular withholding allowances after you receive the bonus income. If you fail to change your allowances back, you could have insufficient withholding for the rest of the year. This could result in a hefty tax bill when you file your next tax return.
If you are deferring income into a retirement plan, such as a 401(k), a portion of the bonus may be withheld for that as well. While there's no eliminating the tax burden of a bonus altogether, you might be able to lower it. Here are some ways to reduce the sting of taxes from your bonus: Reduce your taxable income.