How Bonuses Are Taxed by the IRS
So you just received a bonus. You looked at your pay stub and realized more federal income tax was taken out than your normal paycheck.
But why did this happen?
Are you taxed more on bonus income than regular income?
The short answer: you aren’t taxed any differently on your bonus income.
The IRS just uses a different methodology to withhold taxes from paychecks where you only receive bonus income.
If your bonus was lumped into a regular paycheck, the calculations will likely result in more federal income tax withheld, too.
We have the detailed answers you’re looking for and everything else you need to know about your bonus and federal income taxes.
As always, contact a tax professional if you need advice regarding your specific tax situation.
Are Bonuses Taxed Differently Than Regular Income?
No, bonus income is technically taxed the same as regular wages in the eyes of the IRS.
Let’s say you earn $50,000 in wages and a $5,000 bonus. Another person earns $55,000 in wages and no bonus. A third person earns $25,000 in wages and a $30,000 bonus.
Assuming everything else is equal about these three people’s tax situations, they’d all pay the same amount of federal income tax.
What could be different, however, is the amount of federal income tax withheld from their paychecks and bonus checks.
Taxes May Be Withheld Differently on Bonus Income
The IRS issues guidance each year about how to withhold federal income tax from an employee’s paycheck and from bonuses. This is published in IRS Notice 1036.
The part that deals with bonuses is titled “Withholding on Supplemental Wages”.
Part of how federal income tax is withheld on supplemental wages has to do with whether an employee receives more or less than $1,000,000 in supplemental wages within a calendar year.
Bonus income above $1 million in a calendar year
For the extremely rare situations where you earn more than $1,000,000 in supplemental wages in a calendar year, federal income tax is withheld at 37% on amounts of supplemental wages in excess of $1,000,000.
Bonus income below $1 million in a calendar year
For the vast majority of people that earn less than $1,000,000 in supplemental wages, things are more complex.
Your employer has a few ways they can pay out your bonus:
If bonuses and wages are combined
If your employer combines your bonus with your regular paycheck and doesn’t break out the amount of your bonus and your wages, they must withhold federal income tax according to the usual calculations.
While you’d think this would result in the same percentage of federal income tax withheld as a normal paycheck, it usually doesn’t.
The reason why is federal income tax is withheld based on a complex system that takes your paycheck and annualizes it. Your employer uses tables provided by the IRS to decide how much federal income tax should be withheld from each paycheck.
The tables give an idea of how much income you’ll earn over the year if you’re paid in equal amounts throughout the year.
The tables also take into account a reduction of income based on the number of withholding allowances you selected when you filled out form W-4.
If you get one big bonus once a year, the tables are confused. They think you suddenly are making much more income throughout the year.
In reality, you just received a one time bonus.
Due to the way the tax brackets work, more federal tax is withheld on each additional dollar of income in higher tax brackets.
This can result in this method withholding more federal income tax from your paycheck than regular paychecks both in total dollar amount and as a percentage of your income.
If bonuses are separate from wages
If bonus pay is separately identified from wage pay, your employer has two options to withhold federal income taxes from your bonus.
In most cases:
It is up to the employer to decide which method to use.
However, if your employer didn’t withhold any federal income tax either this year or in the prior year, they must use the second method described below.
Method #1 - Flat Withholding Rate
The first method is easy to understand.
Employers simply withhold 22% of your bonus for federal income tax withholding.
Depending on how much income you earn in a year, this could be more or less than your normal federal income tax withheld.
However, this will result in more tax withheld than normal for most people.
Method #2 - Calculations
The second method is more complicated, but it is basically the same concept as if bonus and wage
Get money back if you're not in higher tax brackets
If your employer decided to withhold federal income tax at 22% or if the calculations resulted in a larger than usual withholding percentage from your bonus paycheck, you may be wondering how to get your money back.
Thankfully, there’s a system in place to handle this.
Each year, you file your federal income tax return. When you do this, the IRS will repay any over-withheld income tax to you in the form of a tax refund.
Essentially, your tax return calculates how much federal income tax you owe based on the income you earned in the tax year.
Then, it adds the amount of federal income tax you had withheld from your paycheck and any estimated income taxes you paid.
If the amounts you paid in, including extra withholding on your bonus, exceed what you owe, you get a tax refund.
If the amounts you paid in, including potential extra withholding on your bonus, are less than what you owe, you should pay the remaining tax owed with your return.
Bonuses for the Self-Employed
What should you do if you’re self-employed and get a bonus? Do you have to follow the same steps as described above?
If you own your own business and are considered a W-2 employee of that business and pay the bonus as W-2 wages, you should follow the guidelines above.
However, if you’re an owner of a business and you aren’t a W-2 employee, you pay your withheld federal income taxes with estimated tax payments.
Instead of following the supplemental wages withholding requirements for employees listed above, you’d follow the guidelines for paying estimated tax payments.
Pushing You Into a Higher Tax Bracket
Bonuses aren’t always predictable.
Depending on your position, a bonus could be a sizeable chunk of money. At the same time, you could get no bonus at all if you or your company doesn’t reach their goals.
Believe it or not, bonuses could push you into the next tax bracket.
Being pushed into the next tax bracket isn’t a big deal.
Thanks to the fact that the federal income tax system is a marginal income tax system, getting pushed into a new tax bracket doesn’t tax all of your income at the new and higher rate.
Instead, only the amount of income in the new tax bracket will be taxed at a higher rate.
Which would you rather have:
- $0 from declining a bonus
- Your bonus less the taxes you’ll owe, only on the additional bonus income (in no instance could you owe more taxes from getting a bonus than the value of the bonus)
Ways You Can Reduce Your Taxes
Whether you receive a bonus or not, there are many ways you can reduce the amount of federal income tax you owe.
Keep in mind:
These are completely legal as long as you follow the laws.
Most taxpayers get a major tax deduction by either claiming the standard deduction or itemized deductions.
The standard deduction is easiest because you don’t have to have any particular documentation to claim it, but some people may benefit more by taking itemized deductions.
Currently, itemized deductions include deductions such as:
- Medical and dental expenses in excess of 7.5% of your adjusted gross income
- State and local taxes up to $10,000 for most filers
- Qualifying home mortgage interest and points
- Gifts to charity
- Casualty and theft losses from a federally declared disaster
In addition to the standard deduction or itemized deductions, you may be able to claim other tax deductions and tax credits to lower your tax bill such as:
- Retirement contribution deductions for 401(k)s, IRAs and other accounts
- Pre-tax health insurance premiums
- Student loan interest
- Health Savings Account contributions
- Home office deduction
- Qualifying education expenses through American Opportunity Tax Credit or Lifetime Learning Credit
- Child tax credits
- Adoption credits
- Earned Income Tax Credit
- Saver’s tax credit
If you do get a bonus and you have some say over when you get it, timing may be able to help you lower your tax bill.
Let’s say you can decide to get your bonus in December Year 1 or in January Year 2. You can look at your projected income and projected tax laws for both years.
If you’ll have significantly less income in year two and tax laws remain the same, you could potentially pay less in taxes by delaying the bonus until January Year 2.
However, if you’ll have lower income in year one and tax laws will remain the same, you’d likely pay less taxes by taking the bonus in December Year 1.
Remember, Bonuses Are Good
Bonuses give you more income -- very difficult to argue against more money.
Unfortunately, the federal income tax withholding may be a bit higher on your bonus than you’re used to.
You’ll still end up with more money overall though.
If the money withheld on your bonus is too high and you’ve correctly had your federal income tax withheld from the rest of your paychecks, you should get a refund for the difference when you file your income tax return.