It is obvious you must pay income tax, but do you pay taxes on your bonuses? The answer is a big YES. They are also subject to federal tax implications. The good news is that knowing how bonuses are taxed can help minimize taxes on them.
Bonus basics: Combined and separate payment
The IRS considers the cash bonuses as supplemental wages (which are not regular wages). Your employer can take taxes on your bonus out of your paycheck for you so that you don’t have to figure that on your own. If your employer decides to pay you as a separate payment from the normal paycheck or indicate it as an item on your paycheck, it will hold back 22% of the cash to go toward the tax bill irrespective of your tax bracket. If the bonus exceed $1 million, withhold federal income tax on the excess amount at 35 percent.
If your employer decided to combine your bonus with your usual paycheck as a lump sum, regular tax rates apply. The tax rate depends on your tax bracket.
Types of bonuses
Bonuses in the form of cash are tax-deductible unless intended to serve as a gift. If designed to serve as compensation for services, taxes must be paid. It is recommended that bonus payments to be done after the service is complete. Not before. The laws governing the deductibility of employee wages require all amounts to be reasonable based on the services performed. This means employers must consider the overall compensation, including bonuses, for each employee.
Property bonuses are also tax-deductible and included on employee W-2 forms. They are subject to the wage and salary deductions’ fairness requirement. But unlike cash bonuses, it is not simple to figure out what that bonus is with. Consider when a business gives out a vehicle it no longer needs as a bonus. In such a case, the best approach would be to use the property’s fair market value on the date of transfer as the bonus amount. Not what the business initially paid for it.
Reasonable employee compensation
Assessing the reasonableness of each employee promotes fair compensation. This further eliminates a scenario where some employees are reasonably compensated and other unreasonably compensated. In fact, if the IRS ever finds that part of an employee’s compensation is an unreasonable amount, the portion thought absurd isn’t deductible to the corporation.
Basically, what an employee gets from the employer (total wage and bonus income) are reasonable if that match what other employers are offering for the same role or would offer the same employer. Factors such as complexity of the job, duties, responsibilities, and skillset help figure out reasonable compensation for each employee.
Achievement award and gifts
Gifts and achievement awards are not treated like bonuses and are taxed differently. Annual deductions for achievement awards are limited to $400 for each employee. For employers with qualified plans (which details the procedures for paying out such awards), the annual deductions for each increase to $1600. For employers who reward their employees with gifts such as movie tickets or holiday parties, they can deduct the full cost. Basically, both gifts and awards are treated as usual business expenses instead of employee compensation.
Federal and state taxes
As aforementioned, your bonus count as supplemental income and subject to federal withholding at a 22% flat rate. See this example for more information.
If you receive a $6,000 bonus for the year, you will likely have $1,320 withheld in federal taxes to be sent to the IRS ($6,000 x .22 = $1,320).
You may also pay state taxes on your bonus. Note that the withholding rate varies based on the state you live in. For example, if you receive a huge bonus, let’s say $1.5 million, a portion of it will be taxed at a higher rate. That is 22% federal tax withheld on the first million and then 37% on the bonus funds above the first million. Here is an example:
If you receive a $2 million bonus, you will pay $590,000 in federal taxes on it
$1,000,000 x .22 = $220,000 tax on first million
$1,000,000 x .37 = $370,000 tax on second million
$220,000 + $370,000 = $590,000 total tax
Social Security and Medicare Taxes
Social Security tax at 4.2%t of the bonus amount and Medicare tax at 1.45% are also subtracted, as of 2012. Social Security tax has an annual wage threshold of $110,100, so you would not withhold Social Security tax on any bonus amount that causes the employee’s wages to exceed that limit. Medicare tax is withheld from all wages. It has no annual limit.
Gross up method
Employers who negotiate a gross-up agreement with their employees pay them the entire bonus sum and absorb the tax liabilities. If the employer agrees to give you $1,000 as a Christmas bonus. That employer would pay the tax cost of $441.96, and you would get $1000.
Offset the bonus tax with deductions
Deductions allow you to reduce your taxable income for the year, something that could reduce your tax liability and help you owe less at tax time.
For example, if you earn a $5,000 bonus at work and can claim a $5,000 deduction, then you essentially would cancel out the tax impact of that income. In other words, you could effectively earn your entire bonus, tax-free, by taking a qualifying deduction for the same amount (or more) than your bonus.
Donate money to charity
You can simply enjoy a tax break by donating your money to a charitable cause you are passionate about. You can deduct donations of up to 60% of your income for a given year. For a seamless process, make sure the charity is qualified to receive tax-deductible donations for you to claim it as a deduction. You can always consult the IRS for eligible groups.
While bonuses will supplement your wage, it is good also to note that they can put a damper on the fun. Luckily understanding how the taxman treat bonuses can help you avoid some tax traps. Still, have a question on bonuses? We are here to help.