With the holidays approaching, many companies are preparing their bonus checks, and employees who are looking forward to their bonuses are concerned about tax consequences.

I gave up this “extra” part of my corporate pay for the benefit of working for myself when I left my day job last year. If this year were anything like what I’ve experienced in the past, people I know would complain that they’d rather not receive a bonus. 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, because it would mean that they owe the government a higher tax rate on all of their income. This is incorrect and represents confusion about marginal tax rates.

These misconceptions and the resulting complaints are intensified when the bonus check arrives with a net payment amount representing only a fraction of the gross income listed on the pay stub.

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, and the same tax rates apply. There is a catch, and this is why confusion is rampant: While the IRS doesn’t discriminate between regular pay and bonus pay, employers often do.

Employers can choose between two methods of withholding federal taxes from bonus or supplemental income when it 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 35% from the amount over $1 million in addition to 25% of the first $1 million.

Option 2. The employer may add the bonus payment to the most recent regular income payment, determine the standard withholding based on tax tables and the sum of the two payments, subtract the amount already withheld from the most recent regular income payment, and withhold the rest from the bonus.

The third 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.

Option 3. The employer may base withholding on the sum of the bonus and regular pay using the standard withholding tables.

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 idea that bonuses are 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%, a rate usually significantly lower than their marginal tax rates.

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.

{ 39 comments }

If you haven’t noticed, it’s tax time. I have noticed, not only because of the relentless emails I receive reminding me of this grand celebration, but also due to people I interact with. As those I know complete their tax returns, I observe the joyfulness they exude as they realize they’ll be receiving a refund from the IRS.

Count me in with the masses; my accountant suggested some changes to my tax returns for the past couple of years, and I received several refunds I otherwise wouldn’t have expected. I exuded an appropriate level of joyfulness, as well.

Most people’s tax situations are much simpler than mine. For example, a single guy might work for only one employer, receive one W-2 form, and won’t have much un-withheld income. He will probably receive a small refund. Or: a family receives two W-2 forms and because they didn’t calculate their withholding correctly they’ll receive a large refund.

The federal government should be the one celebrating. They’ve been using “our” money — money belonging to those of us who are due a refund — for free! Usually, when you lend money to someone, you charge interest to compensate yourself for its use. Why would you give the government, an organization that will use your money in ways you may not approve of, a free ride?

The most common explanation — or rationalization — for not being concerned with lending money to the government for free is because this creates “forced savings.” By having more money than necessary withdrawn from each paycheck, you are putting some money aside for later, counting on the government to pay you back on time.

It might be a good idea to note that some state governments are not issuing refunds on time. The states’ financial difficulties will become your financial difficulties when they delay sending you the “savings” you’ve been counting on.

Here’s why “forced savings” is a poor excuse.

• You are not earning interest. In a high-yield bank account like Discover Bank, the money could earn interest. If you hand excess money to the government each pay period, the government gets to keep any interest it could be earning. You might as well throw money out the window.
• You don’t have use of the money. The average tax refund, for those who receive one, is almost $3,000. You could have used that money to pay off your debt, repair your house, or invest for your retirement.
• Saving yourself isn’t difficult. Don’t rely on the government for a savings plan. You can automatically transfer a portion of your paycheck into a savings account. When you re-calculate your withholding and change the form with your employer, set up direct deposit so you receive your pay directly in your bank account. Then, set up an automated recurring transfer to move a portion of your pay to a savings account earning interest.
• It’s easy to treat a refund wrong. Receiving a large check from the government encourages people to make unnecessary or unplanned purchases. While that might be great for the economy in general, you might be making choices you wouldn’t have been if that money was spread out over the course of the year and incorporated into your weekly or biweekly income.

The federal government counts on millions of citizens overpaying their taxes throughout the year. If everyone optimized their withholding, the government might not be able to pay for its day-to-day operations. Don’t worry about what the government will do; the best decision is to optimize your withholding so you do not receive a substantial refund.

Consider planning your withholding so you owe the government when you file your taxes. In this scenario, all the drawbacks mentioned above become your advantages. You’ve had access to government money throughout the year. As long as you stay within limits, you won’t owe the government any interest or fees. You can earn interest or invest the government’s money, and as long as you can pay your bill by April 15, the government doesn’t care what you do.

Receiving a tax refund is not the worst thing in the world. It’s not efficient for taxpayers, and not the best use of the income you receive from your employer.

When you file your taxes, do you like to receive a refund or prefer to owe the government?

{ 27 comments }