Bonuses are taxed heavily (often close to 50% when combining federal, state, local, and FICA taxes) because the IRS classifies them as "supplemental wages". Employers often withhold federal taxes at a flat 22% rate, or use the "aggregate" method, which combines the bonus with your regular paycheck, pushing you into a higher tax bracket.
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.
The withholding rate for supplemental wages is 22 percent. That rate will be applied to any supplemental wages, such as bonuses, up to $1 million during the tax year. If your bonus totals more than $1 million, the withholding rate for any amount of the bonus above $1 million is 37 percent.
Up to a third of a cash bonus can get swallowed up by the IRS' special tax withholding on cash bonuses, or what it calls “supplemental income,” on top of Medicare, Social Security and state taxes. The federal flat rate for bonus pay is 22% for supplemental income under $1 million.
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.
For a higher rate taxpayer, a £10,000 bonus will instantly be whittled down to £6,000 by income tax. National insurance at 2% would take a further £200, leaving you with just £5,800 of your £10,000 bonus. However, there is a way to (legally) reduce the tax you pay on your bonus, and that's with bonus sacrifice.
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.
Change your W-4
By updating your W-4 (tax withholding form) with your employer and changing your withholding allowances, you can help ensure the right amount of tax is taken out of your regular paycheck. This can help lessen the impact of a large tax hit when you receive a bonus.
The general rule is that employees are taxed at the rate of the marginal tax bracket in which they fall. Let's explain: if their salary is between R 1 and R 216 200, they are in the 18% tax bracket and therefore their bonus will be taxed at 18%.
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. This is called the aggregate method.
When using the percentage method, employers withhold 22% for taxes on the first $1M and an additional 37% on any portion of the bonus over $1M. For example, let's say John receives a $3,500 bonus. His employer will withhold 22% of this bonus for federal taxes.
A $5,000 windfall is a great opportunity to build a foundation for long-term financial security. The right move depends on your current goals, debt, and emergency savings. Paying off high-interest debt is one of the most financially effective uses.
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Because the IRS looks at bonuses as supplemental income instead of regular income, the tax rate for bonuses is higher. Typically, different rules apply to supplemental income, such as how taxes are withheld and reported.
National Insurance contributions (NICs) are also payable on bonuses. For example, if you earn £40,000 annually and receive a £4,000 bonus, it could be taxed at 20% (basic rate) and 8% for NICs, leaving you with significantly less in take-home pay.
Understanding the Bonus Tax Rate
The flat tax rate is 22% for most bonuses. If your income falls into the top tax bracket, your bonus may be calculated at a flat rate of 37%. Bonuses are also subject to Medicare and Social Security taxes. These taxes apply in addition to any applicable federal, state, and local taxes.
But how much are bonuses, usually? This nuanced question troubles many managers who seek to maximize the effectiveness of bonuses for their company. A typical bonus percentage ranges from 1% to 15% of a team member's salary.
Impact of a bonus taking your earnings over 100k
Let's say you earn a £100k salary and – good news – you've been awarded a £1,000 bonus. Ready for the bad news? Not only will this bonus be taxed at 40% (leaving you with £600), but you also lose £500 from your tax-free personal allowance.