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The Myth About Taxation of Work Bonuses
Many believe work bonuses are taxed at a higher rate than ordinary earned income. The truth is that bonuses are actually taxed the same as any other income.
If this is true, then why does your withholding not reflect that fact?
While bonuses may be taxed just like regular wages, payroll companies often calculate withholdings at a different rate for bonuses than that of your other earned income. The withholding rate hinges on the method used for your withholdings. Some companies use the “Percentage Method”; while others use the “Aggregate Method”.
This method calls for a flat “supplemental rate” of 25% to be withheld for taxes. So if you receive a $1,000 bonus, the percentage method would dictate that $250 (25% of $1,000) go straight to the IRS. Employers often choose this method because of its simplicity.
This method requires your employer to combine the amount of your bonus with your most recent paycheck. Then, the withholdings are calculated based on the total amount necessary for that particular paycheck. Because withholdings are calculated based on year-end earnings as if you were earning this amount every paycheck, you’re likely to see excessive withholdings for any pay period that includes a bonus. This is especially true if your bonuses are a large percentage of your income.
Let’s say you get paid $3,000 per month ($36,000 per year) and get a year-end bonus of $6,000. Under the Aggregate Method, your withholdings for that year-end paycheck will be computed as if you receive $9,000 per month in pay. For payroll calculations, that $9,000 is assumed to be 1/12th of your annual salary. Therefore, your paycheck would be withheld as though you make $108,000 for the year instead of the more accurate $42,000 ($36,000 salary + $6,000 bonus). Because the U.S. is on a progressive tax system, the tax rate increases on higher levels of income. So you would see higher withholdings for this paycheck than you will actually face in taxes, since you aren’t receiving this bonus every paycheck.
How To Avoid Over-Withholding
If you know a bonus check is coming and you feel the withholdings will be too high, you can request a decrease in withholdings** for this pay period. This will allow you to keep more of the money now, rather than having to wait until tax time to recoup the over-withholding. Or you can just keep your withholdings at current levels, knowing you can expect an adjustment when your tax returns are prepared.
** Just be careful you don’t swing too far the other way and have your bonus under-withheld. We suggest checking with your tax preparer to ensure you do this correctly.
*** If you change withholdings, be sure to change them back to normal levels after your bonus check.