How Your Bonus Is Taxed
Being awarded a bonus on top of your regular pay can be a welcome sign of appreciation – but sometimes it can be hard to be told the bonus amount and not immediately question, “How much is this really?” That’s because a bonus’s tax withholdings are immediate and can vary based on the size of the bonus and even how it is awarded. Here’s everything you need to know about how your bonus is taxed, plus some strategies to make that tax bite hurt a little less.
Bonuses Are Considered “Supplemental Wages”
The IRS considers any payment an employee receives on top of their normal earnings as “supplemental wages,” including bonuses, tips, commissions and awards. Like regular income, supplemental wages are subject to taxes – but they have their own rules for withholding, depending on how the employer chooses to disburse the funds.
If You Receive a Separate Bonus Check
If your employer gives you a separate bonus check, then it will withhold federal income taxes using the percentage method. This is a flat rate required by the IRS that varies based on the size of the bonus. In 2023:
- For amounts under $1 million, the employer withholds 22%.
- For amounts over $1 million, the employer withholds 22% for the first $1 million but 37% for the remainder.
When it’s time to file your taxes, your bonus will be treated as regular income (Box 1 on your W-2, under “Wages, Tips, Other Compensation”). If you are in a tax bracket that is less than 22%, your employer will have over-withheld, and you will receive a tax refund for the difference (or it will be applied to the tax due on any other income). If you are in a tax bracket greater than 22%, your employer will have under-withheld, and you will owe the difference between what was withheld and your total tax cost.
If Your Bonus Is Included in Your Regular Paycheck
If your employer gives you your bonus in the same check as your regular pay, then it will withhold federal income taxes using the aggregate method. With the aggregate method, your employer adds your bonus and base pay, determines what tax bracket applies and withholds based on that amount. This method takes longer to calculate and runs the risk of over-withholding, but it tends to be more accurate and less likely to leave the employee with a surprise bill come tax time.
Note that regardless of which method the employer uses to calculate federal tax withholding, your bonus will be subject to state income tax (if your state has one) as well as Social Security and Medicare taxes. 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.
Strategies To Mitigate Your Bonus’s Impact on Taxes
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. A bonus can be a sudden and dramatic increase to your taxable income – so you might consider seeking out ways to decrease it. Contributions to your 401(k), traditional IRA or HSA reduce your taxable income while giving your long-term financial plans a boost. If the bonus causes an unusual spike in your income, maybe a bunching strategy – especially with charitable contributions – is appropriate.
- Review your W-2. Sometimes bonuses come out of the blue, but sometimes they are a predictable portion of your total compensation. If you have a good idea on the likelihood, timing and size of your bonus, you might be able to adjust your withholdings accordingly and blunt its impact on your tax bill.
- Defer. If you think next year’s income will be lower (such as for someone headed into retirement) or deductions will be higher, you could ask your employer to wait on awarding you your bonus. Deferring your bonus doesn’t eliminate how much you’d owe on taxes, but it does delay it – just be prepared for the possibility that your employer says no.
Of course, there’s also the issue of what to do with your new fortune. From building an emergency fund to tackling credit card balances to paying off medical debt, there are lots of ways your bonus can benefit you now and long into the future. Your Baird Financial Advisor can review with you your options so you’re making the most of this opportunity.
The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.