If you’re an American who got cut a bonus check last year, the extra cash was probably a welcome addition to your regular paycheck. But if you read the fine print, you’ll notice the taxes withheld seem like a bigger chunk than those held back from your regular wages.
So what gives, and why does the IRS take a larger bite out of your bonus?
To answer that question, it helps to know that bonuses are taxed differently regardless of your tax bracket. Here’s what you need to know about how bonuses are taxed, the bonus tax rate, and how federal withholding works for supplemental income like bonus pay.
When it’s tax time, a bonus is part of your taxable income, and you’re expected to report it as such on your federal income taxes. That’s because bonus money is considered a supplement to your regular pay.
“Supplemental wages are wage payments to an employee that aren’t regular wages. They include, but aren’t limited to, bonuses, commissions, overtime pay, payments for accumulated sick leave, severance pay, awards, prizes, back pay, reported tips, retroactive pay increases, and payments for nondeductible moving expenses,” the IRS 2024 Publication 15 Employer’s Tax Guide to Wages and Other Compensation states.
There are some exceptions to whether a bonus gets added to your tax bill. Company parties and employee discounts or other fringe benefits are generally exempt, as is the occasional meal or gift of nominal non-cash value.
Read more: What is taxable income?
According to the IRS, supplemental wages don’t have to be cash to be taxable. The following types of compensation are considered a cash equivalent, meaning they’re part of your regular income and are subject to income tax withholding.
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Signing bonuses or incentives
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Severance pay
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Accumulated sick leave
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Some commissions
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Overtime pay
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Back pay and retroactive pay increases
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Non-deductible moving expenses
The IRS also specifies to employers that “any fringe benefit you provide is taxable and must be included in the recipient’s pay unless the law specifically excludes it.” Some of the benefits the IRS excludes from income tax liability include employee achievement awards up to a certain amount, a health savings account up to the contribution limit, employer-provided cell phones, gym memberships, and other benefits like tuition or adoption assistance.
If you noticed that your bonus seems to be taxed at a different withholding rate, you’re not wrong. There are two different methods for how much tax the payroll department deducts.
Here’s how the two different methods work for bonus payments and why your employer might prefer one method over the other.
Method 1: The percentage method
Many employers prefer the percentage method because the withholding rate is straightforward. This flat rate method requires your employer to withhold 22% of your bonus, plus an additional 7.65% for Medicare tax and Social Security taxes. Note that the IRS limits Social Security tax withholding to the first $168,600 of wages for 2024.
These bonus tax rates apply regardless of your tax bracket up to the first $1 million. If you receive more than $1 million in bonuses, 37% will be withheld on any amount above that. Unless you’re a highly paid CEO or part of the executive team, most people in a lower tax bracket aren’t paying a 22% marginal income tax rate. So come tax time, you’ll likely get a tax refund on the excess withholding.
Here’s an example of how it works:
Let’s say you get a $3,000 bonus. Your employer uses the flat rate percentage method and deducts 22% off the top, resulting in $660 of federal tax withholding. But because you’re married filing jointly with less than $89,450 in adjusted gross income, your tax rate is actually 12%. With a flat rate method, the IRS would owe you about $300 on your bonus withholdings come tax time.
Bonuses taxed using the aggregate method can be a bit trickier. Your employer lumps your bonus into one paycheck for a pay period, then takes out taxes according to your normal withholding rate, in addition to Social Security and Medicare taxes.
If you’re in a higher tax bracket, this results in less of your bonus in your pocket up front, while those in lower brackets will walk away with more in their paycheck. See the example below to get a better sense of how the way your employer pays taxes on your bonus can change your tax burden.
Returning to the example above, you get a $3,000 bonus and file a joint return on income of less than $89,450. If your employer used the aggregate method, your bonus would already be taxed at 12%, resulting in a withholding of $360. While you wouldn’t get a tax refund, you’d pocket more of your bonus upfront.
Gearing up to get a big bonus this year? You don’t have to be a tax professional to use the following tips on scoring some tax savings.
If the anticipated bonus is large enough to bump you into a higher tax bracket, increase your withholding amount on your W-4 now.
Not sure if you’re withholding at the right tax rate? Here are the current IRS tax brackets, and marginal tax rates, for each tax filing status.
Any financial adviser worth their fee will tell you that to lower your tax liability from a large bonus, you should lower your taxable income.
This would include strategies like making charitable donations, claiming applicable tax credits, and maximizing your tax deductions to account for student loan and mortgage interest, business expenses, educational and healthcare expenses, and more.
Read more: Standard deduction vs itemizing: How to decide
Tax-advantaged accounts are a key way Uncle Sam lets you save tax-free (or tax-deferred) for certain big-ticket expenses such as retirement, healthcare, and college.
You can offset the tax burden of your bonus by squirreling it away in an eligible 401(k), IRA, HSA (Health Savings Account), flex spending, or other tax-advantaged account as long as you don’t exceed the annual contribution limits.
If you think you’ll be making less money next year, you could ask to defer your bonus or split it between this year and next year. That way, you’d push some of that extra money into a tax year when your overall income is lower. Consider this option only if you can wait for the cash or if you expect your personal finance situation to change.
There is some risk that the chunk of change allotted to you might not be around next year (or you might not be around to receive it). So pursue deferring or splitting a bonus only if you’re confident about your employment status.
Read more: Expecting money back? Here are 5 smart ways to use your tax refund.
Yes. While the amount of taxes can vary, your employer must use the percentage or aggregate model to calculate the federal tax withholding from your bonus — and for any supplemental income or cash equivalents that qualify as taxable income.
If you have questions about whether the bonus you received is taxable income, consult the IRS guidelines for taxpayers on taxable and non-taxable income.
It’s not just the IRS that counts your bonus as supplemental wages. Several states also apply an added percentage on bonuses for state income taxes. This is usually assessed as a flat rate on your bonus amount.
The rate is between 5%-7% depending on where you live and your adjusted gross income, so consult your state tax guidelines for more details about what you’ll owe when it’s time to file your tax return.
