Why Are Bonuses Taxed Higher Than Ordinary Income?
Your bonuses are taxed higher compared to your regular income because the IRS treats bonuses differently. How does the IRS tax bonuses?
Dec. 9 2020, Published 11:49 a.m. ET
While bonuses are subject to income taxes, they aren’t simply added to your ordinary income and taxed at your top marginal tax rate. Instead, the IRS considers bonuses to be supplemental wages. The IRS charges a flat 22 percent federal withholding rate on bonuses. For example, if you receive a $5,000 bonus for the year, you will likely have $1,100 withheld in federal taxes to be sent to the IRS.
A supplemental wage is money paid to an employee that isn’t part of his or her regular income, according to the IRS. Examples of supplemental wages include signing bonuses, accumulated sick leave, severance pay, overtime pay, prizes and awards, reported tips, retroactive pay increase, and certain commissions.
What taxes will you have to pay on a bonus?
Employers pay bonuses to reward valued employees for superior performance. Most employers follow this practice because a bonus is a proven way to retain and motivate employees. A bonus is money paid over and above normal wages. The IRS considers bonuses to be supplemental income, which is similar to commissions.
Supplemental income is taxed the same way as normal pay. When an individual files the tax return, supplemental income is combined with normal wages and is subject to the same taxes and tax rates. Bonuses are subject to federal income tax, Medicare tax, and Social Security tax. State income tax might also apply based on where you live.
How are bonuses taxed?
Employers can compute supplemental income withholding taxes in two ways. They can use the percentage method or the aggregate method. When an employer taxes your supplemental wage using the percentage method, it must identify the supplemental wage separate from normal wages. In the percentage method, the withholding tax rate for a bonus is 22 percent. If your supplemental wage totals over $1 million, the withholding tax rate for any amount more than $1 million rises to 37 percent.
Sometimes employers pay bonuses alongside normal wages. In this situation, your employer must use the aggregate method to determine the initial tax withholding on your supplemental income. The withholding tax rate is based on your regular income tax rate.
Most employees’ paychecks are subject to maximum federal income tax rates of 10 percent or 12 percent. As a result, it seems that bonuses are taxed at higher rates.
Which method of tax withholding on bonuses is best?
Usually, the percentage method is a lot simpler. As for which benefits the employee the most, it depends on your tax bracket. The tax withholding on your supplemental wage is going to be higher in the aggregate method if you are in a tax bracket that is above 22 percent, like the 24 percent or 32 percent tax bracket. If you are in the 12 percent bracket, you can ask your employer to use the aggregate method.
If your supplemental wage is only a few hundred dollars, there isn't much you can do about taxes. If you received a significant amount of cash, you could use your supplemental income wisely to reduce the tax liabilities. For example, you can use the bonus funds to invest in your 401(k) to get a tax break.