Bonus Tax Rates 2022: How Are Bonuses Taxed & Who Pays? - Tax Professionals Member Article By Taxes Made EZ Inc
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Bonus Tax Rates 2022: How Are Bonuses Taxed & Who Pays?

Bonus Tax Rates 2022: How Are Bonuses Taxed & Who Pays?

Bonuses are considered extra pay and are taxed by the IRS as ordinary income. There are two ways for your employer to determine how much to deduct from your salary.

Earning a bonus does feel like a well-deserved reward. After all, who wouldn't want a pat on the back and a little extra cash? But you might be surprised when your paycheck comes in, and you realize, "Wait a minute, is that taxable too?"

Bonuses are effectively taxable. And how they're sliced and diced depends on a few things, including the employer's calculation method.

Here's a quick guide to how bonuses are taxed, the two methods employers can use to calculate their withholding tax, and some tips for minimizing the tax impact of a bonus.


What is a bonus?

A bonus is compensation given to a worker at the company's discretion. Bonuses are usually lump sums paid on top of a worker's salary or wages.

Usually, bonuses are given out on special occasions (e.g., holidays) or incorporated into certain compensation plans (e.g., for meeting a quarterly sales goal). Other types include annual, merit, referral, signing, and retention bonuses.


How are bonuses taxed?

The IRS considers all bonuses you receive as income.

In the short term, your employer will withhold part of this bonus from your salary to pay taxes. And the fun doesn't stop there - you may also have to pay Social Security, Medicare, and state taxes (sometimes called FICA taxes) on the bonus.

Over time, the bonus will be added to your total income for the year. The total bonus amount you received during the year will be combined with other income and reported in box 1 of your W-2.

When it is time to file your annual taxes, your total income, including the bonus, is taxed at your effective tax rate. Employers deduct tax from your salary throughout the year to prepay this tax on your behalf. If you have withheld enough, you owe nothing. If you withhold too little or too much, it could mean a tax bill or a refund.


Tax Withholding on Bonus

Unlike your regular income, the IRS groups bonuses (and other things like severance pay and commissions) into a category called "supplementary wages."

And this is where the confusion often arises.

Although IRS tax bonuses are like ordinary income, your employer can use two different methods to calculate withholding tax. In other words, your employer can choose how they want to calculate your salary. And how those numbers are processed can affect two things: the amount of bonus you'll see on your paycheck and your overall tax liability for the year.

The two methods the Internal Revenue allows for calculating withholding tax and other forms of supplemental income are the percentage method and the aggregate method.


1. The percentage method

If you receive a bonus separate from your regular salary, your employer will likely use the percentage method to calculate the amount of tax to withhold on your bonus.

  • Your total annual bonuses are taxed at a flat rate of 22% if they are less than $1 million.

  • If the total bonus exceeds $1 million, the first million dollars will be taxed at 22%, and each dollar above will be taxed at 37%. Your employer is expected to use the percentage method if the bonus exceeds $1 million.


How it works:

Advantage: This percentage method is relatively easy for the employer, so you will often see tax withheld this way on bonuses.

Disadvantage: The disadvantage of this method is that the effective tax rate for most people is not 22%. If you're in a higher tax bracket, you may not have had enough tax deductions, which could result in a surprise tax at the end of the year. On the other hand, if you fall into a lower federal tax bracket, your bonus may be taxed at a higher rate than your regular income. This means that more of your bonus will be withheld, but you can get a tax refund when you file your return.


2. Aggregate method

The aggregate method is the second option employers calculate withholding tax on a bonus. This usually happens when your employer combines your bonus and regular salary into one paycheck.

  • Bonuses and regular earnings/salaries are combined into one salary.

  • The payroll department will levy taxes on the entire aggregated salary at the same rate. This withholding rate depends on your filing status and the information provided on your W4.


How it works:

Advantage: While it is not perfect, the aggregate method will likely ensure that you withhold enough to cover your tax liability. Translation: There's less chance of a surprise tax bill because of your bonus.

Disadvantage: it takes more work for the employer to calculate, and it is always possible to withhold a lot, which can mean a larger share of your salary than necessary. But it also gives you a better chance of getting an accurate deduction for the year or possibly a refund.

 

Aggregate Method vs. Percentage Method

The bottom line is that neither the percentage method nor the aggregate is an exact science. Regardless of the calculation method, be aware of the total withholding for the year if you earn a bonus. Knowing your total income, you can play around with your W-4 and adjust your withholding to get things started before tax hours.

 

How to minimize tax impact of a bonus

1. Check your W-4

As bonuses can appear at any time of the year, they are gradually added to your salary. And it can inflate your income, pushing you into a new tax bracket and increasing your tax liability.

Before or after paying your bonus, it may be worth doing some maintenance on your W-4 to adjust your deductions. Calculating how much to take can be tricky, but a tax professional can help you know if you're on the right track to pay, get a refund, or eliminate your tax liability. A little manipulation can help keep a tax bill under control.


2. Make sure your bonus is taxable

Make sure the bonus you get is really a bonus. The IRS has rules about what is considered taxable. Things like occasional event tickets, holiday gifts, overtime meal money, flowers, books, and other low-value intermittent perks are generally non-taxable.

But things get dark once your employer hands you money, gives you a gift card, or gives you a high-value gift. Consult a tax professional if you have questions about the tax implications of a gift or award.

 

3. Tax deductions

Tax deductions are one of the most popular ways to reduce your taxable income and help offset some of your tax liability. Most taxpayers benefit from the standard deduction, but if your tax-deductible expenses, such as unreimbursed medical expenses, gifts, or mortgage interest, amount to more than the standard deduction, itemizing them can help reduce your taxable income and save money on taxes.

 

4. Contribute to a tax-exempt account

When it comes to tax mitigation strategies, this can be beneficial for most people.

If you haven't reached the annual contribution limit for a tax-efficient plan such as a 401(k), HSA, or traditional IRA, consider using your bonus for a qualifying contribution. Since the money you put in these accounts is pre-tax, you can reduce your taxable income by directing your hard-earned salary toward a long-term savings goal.

 

5. Defer your bonus

Also, some people can ask the employer to defer the bonus to the following year. It is important to note that this does not eliminate any taxes due; it simply postpones the payment of taxes later. This strategy can make sense if:

  • You think your bonus will put you in a higher tax bracket, and you need more time to save for the taxes you owe.

  • You know your total income next year will be less than this year, which could reduce your tax liability.

Because this can be a tricky strategy to navigate, be sure to consult with a tax professional to ensure this is the right decision for your finances.


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