Many people look forward to getting a year-end bonus from their employer, but the numbers don’t always add up as well as many bonus recipients may hope. For some, the year-end bonus may be a relatively small amount, but for others, especially high-performing employees, the amount can be pretty impressive.
Workers getting bonuses may have big plans to use a year-end bonus to finance major purchases, vacations, home renovations, or to pay off debts. However, many employees expecting a bonus may be sadly surprised when it arrives and discover it isn’t as much as planned.
So what can turn a nice, chunky, year-end bonus into a paltry let down? Mainly, and perhaps unsurprisingly, the issue is related to taxes. Bonuses fall into a payroll category called “supplemental wages” and are taxed differently than regular earnings. According to the IRS, supplemental wages ” include, but are not limited to, bonuses, commissions, overtime pay, payments for accumulated sick leave, severance pay, awards, prizes, back pay, retroactive pay increases, and payments for nondeductible moving expenses. Other payments subject to the supplemental wage rules include taxable fringe benefits and expense allowances paid under a nonaccountable plan.”
There are two different ways employers can manage the withholding requirements. One way to do it is through the “percentage method” in which a 25 percent tax is taken out by the employer and forked over to the Internal Revenue Service on an annual bonus. This means a $10,000 bonus translates to a $7,500 check; a $2,000 bonus will yield a $1,500 paycheck, so it is important to manage expectations when anticipating a year-end bonus check.
Anyone lucky enough to be expecting a bonus over $1 million will have to shell out a bit more. In this case, the 25 percent rate is withheld up to $1 million, then the rate over $1 million is taxed at 35 percent. I’m sure most of us now feel quite relieved to not be in such a position.
The second method employers can use is called the “aggregate method” for withholding. Under this method, the employer simply adds the bonus to a regular paycheck. The result is often a much higher tax rate. This can result in the entire check being taxed at a much higher rate than the amount that would normally be taken out for wages. Under this scenario, not only is the bonus smaller, but the regular earnings portion of the check could be smaller, too.
The second method is easier for employers to implement since it doesn’t require issuing special paychecks with different rules from regular checks. It’s not always a good scenario for the employee, however. The amount of taxes withheld on the bonus may exceed the 25 percent flat rate in the first method and result in a lower payout. Or the amount withheld could be lower than 25 percent, making the tax burden higher at the end of the year.
With either method, the real amount of money paid in taxes at the end of the year will change based on the total gross income when filing at tax time. The advantage of having the amount deducted right away is clear: the overall amount owed in annual taxes will be reduced by the amount withheld and will already be paid to the IRS.
However, another pitfall may lurk in the shadows of the greatly desired year-end bonus. Because supplemental wages still contribute toward an employee’s adjusted gross income, they are subject to social security, Medicare, and other taxes, and the income may push the employee into a higher tax bracket. Once a higher bracket is breached, the bonus recipient could be saddled with a higher tax percentage rate on their total annual income.