How bonuses are taxed, and the surprise effect they can have on your payroll withholding

For many of our clients, especially those working in industries such as management consulting and finance, bonus season is an important time as the amounts paid are often a large percentage of overall compensation.

However, despite the intense interest in the size of bonuses, the way in which bonuses are taxed is often very much misunderstood. This article clarifies how bonuses are taxed and makes you aware of steps you may need to take to keep your payroll withholding optimized.

How are bonuses taxed?

Let’s clarify one thing right away: income from bonuses and income from salary are treated equally on your tax return. Bonuses are subject to the same rates as any other form of wage compensation. That means, whether you earned (a) $100,000 in salary and $50,000 in bonus or (b) $150,000 all in salary, your total tax liability will be identical.

But why did so much tax get taken out of my bonus paycheck?

This is where the confusion often lies.

When you receive a bonus, the IRS gives your employer two options for how to treat the payment on your paycheck. For bonuses less than $1 million, your employer can either: (1) add it to your standard wages or (2) list it as supplemental income.

If your employer chooses option 1 and lists it as standard wages, then you likely saw a large portion of the bonus payment withheld for taxes.

Why? Because our payroll withholding calculation tables are relatively rudimentary (we’re being blunt but honest here..). Since it was added to your paycheck as wages, the withholding calculation assumes that you will receive this one-time bonus in each of your future paychecks, thus assuming you will be earning a LOT of money this year, which bumps you into the highest withholding bracket. In 2018, that could mean 37% of your bonus is withheld for federal taxes alone, not even including any state tax withholding.

If on the other hand, your employer chooses option 2 and lists it as supplemental income, then a withholding rate of 22% is automatically applied for federal income taxes.

Sound low? That’s because it likely is. For anyone earning more than $82,500 (if single) or $165,000 (if married), then you are already in at least the 24% marginal tax bracket. That means the actual tax liability associated with the bonus income would be higher than what was withheld from your paycheck.

So, this all washes out in the end?

That’s a nice way of putting it. Yes, it will wash out in the end. But that doesn’t make it a fun process when you file your taxes.

If your employer used option 1 and over-withheld taxes from your paycheck, then you will likely be getting a big refund when you file your tax return. There’s nothing wrong with a refund, except when you realize you essentially made a 0% interest loan to the government. For those of you who receive the actual bonus payment in January, you might not get this money back until the following April – that’s a 15-month 0% loan to the government!

And, if your employer used option 2 and under-withheld taxes from your paycheck, then you could be surprised with a tax balance due when you file your return. Depending on how much you owe, the IRS might even charge you an underpayment penalty. Talk about a nasty surprise.

So, yes, it all washes out in the end. But we don’t recommend it as a best practice.

What other options do I have?

Great question! The first thing we recommend is a tax projection. Why wait until April to figure out whether you are owed a refund or have a balance due? We likely can come up with a very good estimate already.

Based on the result of that projection, there are a few courses of action that you might decide to take:

  1. Nothing: If the amount of your refund / balance due isn’t much, then you might decide to leave it alone. At least you can rest easy knowing you won’t be surprised come April.
  2. Adjust Your W-4 allowances: It’s easy to adjust the withholding rate on Form W-4 on file with your employer to either have more or less tax withheld from your paycheck the remainder of the year.
  3. Make an Estimated Payment: If you know you are under-withheld, it might make sense to make an estimated tax payment to save yourself from underpayment penalties.
  4. Charge the IRS Interest: Just kidding. This unfortunately is not an option. They can charge us penalties for underpaying, but we don’t get to charge them interest when we overpay.

Takeaways

For those of you whose bonus payments comprise a big component of your compensation, be sure you understand which methodology your employer used to calculate your withholding.

If there is concern that you might be significantly under- or over-withheld on your taxes, work with a tax advisor on a tax projection. Based on those results, determine whether adjusting your withholding via Form W-4 or making an estimated tax payment is appropriate / necessary.

Reach out to Visor if you need help. It’s easy to get started with a tax advisory call.

Have unanswered questions? Leave a comment on this post and we’ll reply ASAP.

 

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