With the holidays approaching, many companies are preparing their bonus checks. However, some employees who are looking forward to their bonuses are also concerned about tax consequences.
I gave up this “extra” part of my corporate pay, in exchange for the benefit of working for myself, when I left my day job a few years ago. An annual bonus was certainly an appreciated part of my income, however. However, if this year’s holiday season is anything like years past, I know I can expect people around me to complain that they’d rather not receive a bonus. But why?
There is a widely-held belief that the extra income from a bonus — which is not really extra, just a variable aspect of compensation — supposedly bumps them into a higher tax bracket. This, they believe, is bad. They believe that they could potentially owe the government a higher tax rate on all of their income. This is incorrect and represents confusion about how marginal tax rates work.
These misconceptions and the resulting complaints are intensified when the bonus check arrives. Typically, they’ll see a net payment amount representing only a fraction of the gross income listed on their pay stub. This only fuels the anti-bonus fire.
What a Bonus Actually Does to Taxes
For most taxpayers, the IRS treats bonus income the same as regular income. All taxable W-2 income gets added together in one box when you file your federal tax return forms. The same tax rates apply to each dollar shown, whether it came from your 9-to-5, your side hustle, weekend babysitting, or a holiday bonus.
There is a catch, though, and is the reason this confusion runs rampant. While the IRS doesn’t discriminate between regular pay and bonus pay, employers often do.
How Employers Calculate Taxes
Employers can choose between two primary methods of withholding federal taxes from bonus or supplemental income. This applies when said “extra” income is given to the employee in a check or direct deposit separate from regular income.
Option 1: The employer may withhold a flat 25% for federal income taxes from the bonus payment. If the employee receives over $1 million in bonus payments in one year, the employer can withhold 25% of the first $1 million in addition to 35% from the amount over $1 million.
Option 2: The employer may add the bonus payment to the most recent regular income payment. They would then determine the standard withholding based on tax tables and the sum of the two payments. Then, subtract the amount already withheld from the most recent regular income payment, and withhold the rest from the bonus.
*Option 3: The employer may base withholding on the sum of the bonus and regular pay using the standard withholding tables. *This option is for employers who choose to combine bonus compensation with regular compensation in one payment, check or direct deposit, without any differentiation between the two types of income.
Regardless of the method the employer chooses, bonus income and regular income are grouped together when you file your taxes. The IRS will refund any overpayment and will collect any underpayment.
One interesting exception to the rule of bonuses being taxed the same as all other income applies to hedge fund and other investment managers. This type of income is known as carried interest. Investment managers often take their bonuses from investment gains, and these can be taxed at the long-term capital gains rate of 15%. This rate is usually significantly lower than their marginal tax rates.
My Final Advice
Don’t be afraid of earning that bonus or more money in general. Your employer might withhold more of the check for taxes than you’re used to, but it will even out when you file your taxes.
Published or updated December 2, 2016.