How bonuses are designed (and why it matters)

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If you’re an American whose bonus check was cut last year, the extra cash was probably a welcome addition to your regular paycheck. But if you read the fine print, you’ll notice that the withheld taxes appear to be a much larger portion of your regular paycheck.

So what does it give, and why does the IRS take a big 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 the federal deduction works as a bonus payment for extra income.

At tax time, the bonus is part of your taxable income, and you’re required to report it on your federal income taxes. This is because bonus money is considered a supplement to your regular payout.

“An additional salary is a payment that is not a regular salary to an employee. They include, but are not limited to, bonuses, commissions, overtime pay, accrued sick leave payments, severance pay, bonuses, awards, back pay, reported tips, reimbursement increases, and payments for non-deductible moving expenses. 2024 Issue 15 Employer’s Tax Guide for Wage and Other Compensation States.

There are some exceptions to the bonus being added to your tax bill. Company parties and employee discounts or other benefits are generally exempt, as is the occasional meal or gift of non-monetary value.

Read more: What is taxable income?

According to the IRS, extra wages don’t have to be cash to be taxed. The following types of compensation are considered cash equivalents, meaning they are part of your regular income and are income tax deductible.

  • Signing bonuses or incentives

  • Severance pay

  • Accumulated sick leave

  • Some commissions

  • Overtime pay

  • Back pay and back pay increases

  • Non-deductible moving expenses

The IRS also states to employers that “any benefit you provide is taxable and must be included in the recipient’s pay unless the law provides otherwise.” Some of them The IRS does not include benefits They range from income tax liability to limited employee achievement awards, health savings accounts to contribution limits, employer-provided cell phones, gym memberships, and other benefits such as tuition or adoption assistance.

If you notice that your bonus seems to be taxed at a different withholding rate, you are not wrong. There are two different methods of determining how much tax is deducted from the payroll.

Here’s how the two different methods for bonus payments work and why your employer should choose one method over the other.

Method 1: Percentage method

Many employers prefer the percentage method because the deductible is simpler. This flat rate method requires your employer to withhold 22 percent of your bonus plus an additional 7.65% for Medicare taxes and Social Security taxes. The IRS limits Social Security taxes to the first $168,600 in wages for 2024.

These bonus tax rates apply up to the first $1 million regardless of your tax bracket. If you receive a bonus of more than $1 million, 37% will freeze on that amount. Unless you are a highly paid CEO or part of the executive team, most people in the lower tax brackets are not paying the 22% marginal income tax rate. So come tax time, you can get a tax refund on a generous deduction.

Here’s an example of how it works:

Let’s say you get a $3,000 bonus. Your employer uses the flat percentage method and deducts a maximum of 22%, which is a $660 federal tax deduction. But since you file jointly with an adjusted gross income of less than $89,450, your tax rate is actually 12 percent. Under the pro rata method, the IRS owes about $300 in bonus deductions after tax time.

Bonuses paid using the lump sum method can be a bit tricky. Your employer collects your bonus in one check per pay period, then taxes it as your standard deduction, plus Social Security and Medicare taxes.

If you’re in a higher tax bracket, this will reduce the amount of your bonus in your pocket up front, while those in the lower bracket will take home more with their pay. See the example below for a better understanding of how the way your employer pays taxes on your bonus can change your tax burden.

Going back 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 uses the general method, your bonus will already be taxed at 12%, resulting in a $360 deduction. Even if you don’t get your tax refund, you’ll pocket the extra bonus up front.

Are you getting ready for a big bonus this year? You don’t need to be a tax professional to use the following tips to score some tax savings.

If the expected bonus is enough to put you in a higher tax bracket, add the withholding amount on your W-4 now.

Not sure if you’re paying the right amount of tax? Here are the current IRS tax brackets and marginal tax rates for each tax filing status.

Any financial advisor worth their salt will tell you that to lower your tax liability from a large bonus, you must lower your taxable income.

This includes things like making charitable donations, claiming applicable tax credits, and taking your tax deductions for student loan and loan interest, business expenses, education and health care expenses, and more.

Read more: Standard Deduction and Itemization: How to Determine

Tax-advantaged accounts are a key way Uncle Sam can save tax-free (or tax-deferred) for some big-ticket expenses like retirement, health care, and college.

As long as you don’t skip annual contributions, you can offset the tax burden of your bonus by stashing it in a qualified 401(k), IRA, HSA (health savings account), variable spending, or other tax-advantaged account. Limitations.

If you think you’ll make less money next year, you can ask to defer your bonus or split it between this year and next year. That way, you push some extra money into the tax year when your total income is lower. Consider this option only if you can keep the money or if you expect your personal finances to change.

There is a risk that the change class assigned to you may not occur (or receive) in the next year. So pursue bonus deferral or split only if you are sure about your employment status.

Read more: Are we expecting a refund? Here are 5 smart ways to use your tax refund.

Yes. While the tax rate can vary, your employer must use a percentage or gross model to calculate the federal tax deduction for your bonus — and any additional income or cash that’s treated as taxable income.

If you have questions about whether the bonus you received is taxable income, consult the IRS instructions for taxpayers Taxable And Non-taxable income.

The IRS isn’t the only one that considers your bonus as extra pay. Many states apply an additional 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’s tax guide for more details on what you owe when it comes time to file your tax return.