So, the conversation might go something like this.
Your boss: Merry Christmas. Here’s a $1,000 bonus!
You: Woo-hoo! Let’s make it rain dollar bills!
Uncle Sam: Not so fast.
If you’ve ever gotten a bonus, you’ve been there, right? After taxes, that $1,000 drops to $780.
So, what’s the deal? Are bonuses taxed higher than your regular paycheck? Well, it seems that way . . . but not really.
As with any income, you have to pay state and federal taxes on your bonuses. But since they’re considered supplemental wages by the IRS, bonuses are subject to a flat 22% withholding rate, no matter which tax bracket you’re in. Many employers opt to withhold 22% of your bonus, but there are actually two methods for withholding. We’ll talk about that next.
Tax Methods and Withholdings for Bonuses
Employers have the option to withhold taxes for bonuses in two different ways: the percentage method and the aggregate method. Ugh, complicated accounting jargon. No, thanks. But hang with us—it’s really a lot simpler than it sounds.
When an employer uses the percentage method (also known as the flat rate method), the IRS requires them to withhold a flat 22% of your bonus to cover taxes.1 And don’t forget about Social Security and Medicare taxes. That’ll be another 7.65%.
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It might seem like the IRS taxes bonuses at a higher rate than your normal tax rate, but the 22% is just your tax withholding, not the actual amount of taxes you’ll owe when you file your taxes. Remember, bonuses are considered taxable income just like wages and salaries.
The flat 22% withholding applies to any bonuses you receive up to $1 million, regardless of what tax bracket you’re in. So, if you’re in a lower tax bracket, you’ll probably get a refund on those withholdings when you file your taxes. If you’re in a higher tax bracket—say the 24% or 32% bracket—you’ll probably have to cut a check to Uncle Sam come tax time.
If you do earn more than $1 million in bonuses in a year (we’re guessing you’re a CEO or really good at throwing a football or baseball), the tax withholding rate is 37% for any amount over $1 million.
Many employers choose the percentage method because it’s easy. Withhold 22% and boom—you’re done doing math for the day.
With the aggregate method, your employer adds your bonus to your regular paycheck and then withholds taxes at your normal rate based on the info you provided on your W-4. If you work for a big company, you can see how this might be more complicated for your payroll department than withholding a flat 22%.
If you’re in a lower tax bracket, the aggregate method means you’ll get more of your bonus in your take-home pay. If you’re in a higher tax bracket, you’ll get less of your bonus in your take-home pay.
Now, here’s where it gets a little tricky. If you’re in the 22% bracket ($41,776–89,075 for single filers or $83,551–$178,150 for couples), the aggregate method will probably allow you to keep a little more of your bonus in your paycheck. This is because when you’re in the 22% tax bracket, you don’t actually pay 22% taxes on all of your income.
Here’s the quick explanation: Federal income tax rates are progressive, so that means part of your income is taxed at 10%, another piece at 12%, then 22% and so on depending on how high your income is. So, you might be in the 22% tax bracket, but your average tax rate is much lower than 22%.
How to Prepare for Bonus Taxes
If you already know you’re getting a bonus, you can plan ahead for how it will impact your taxes. A bonus, especially a big one, can bump you up into a higher tax bracket. Hey, no one’s going to say no to extra money. But you can still be smart about it so you don’t increase your tax burden.
Say your adjusted gross income is sitting right at $165,050—$5,000 below the line between the 24% and 32% tax rate. You crushed your sales goals for the year, and your boss gave you a $15,000 bonus. When it comes time to file your taxes, you’ll pay 24% in taxes on $5,000 of your bonus and 32% on the remaining $10,000 of your bonus. Bummer. That’s a big chunk of change.
Hey, you worked hard for that money! So, how do you avoid giving 32% of it to Uncle Sam? The key is lowering your taxable income. If you’re out of debt and have an emergency fund with 3–6 months of expenses, one great way to lower your taxable income is to put your bonus money in your 401(k). Contributions to a traditional 401(k) are tax deductible, and that means they lower your taxable income. The annual limit for 401(k) contributions is $20,500.2
If you have a health savings account (HSA), you also can deposit money into it to lower your taxable income. For 2022, the limit for HSA contributions is $3,650 for an individual or $7,300 for a family.3
Another option is to ask your employer to give you all or part of your bonus next year. Yeah, you’ll have to wait to get your cash, but the tax savings could make it worth it. But you’ll only save on your taxes if you expect to earn less next year. So, if you had a banner sales year that you don’t expect to repeat or your spouse is quitting their job to stay home with the kids, ask your employer if they can delay your bonus.
If you itemize deductions, charitable contributions also lower your taxable income.
But remember, you don’t want to make any of these moves just for the tax break. If you’re in debt, saving up your emergency fund, or know you’re about to have a kid in college, that bonus cash will come in handy even if it means the Tax Man walks away with a little more of it.
What Kind of Bonuses Are Taxable?
The IRS classifies bonuses as supplemental wages, and supplemental wages are taxable. Other types of supplemental wages include commissions, payments for accumulated sick leave, severance pay, prizes, back pay, taxable fringe benefits, retroactive pay increases and payments for nondeductible moving expenses.4 That’s a pretty big list, but you’ll be happy to know there are a handful of non-cash bonuses that are tax exempt.
Some of these tax-free bonuses include parties, occasional meals, tangible (non-cash) gifts or prizes of nominal value, and employee discounts. Yep, you don’t have to pay taxes on the “jelly of the month” club membership your employer gave you for Christmas. (It’s the gift that keeps on giving.)
Win at Tax Time
Getting a bonus is great, but it can complicate your tax situation. If you’re confident you can wrangle your taxes on your own, Ramsey SmartTax is simple tax software with no hidden fees. But if you want a tax pro to guide you on your tax journey, a RamseyTrusted Endorsed Local Provider (ELP) can help.