The exact answer to this question depends on your employer. The IRS gives employers two methods they can use when determining how much tax to withhold when disbursing your bonus payment. Employers can use the percentage method or the aggregate method.
Below, we explain both methods and some of the benefits and drawbacks of each.
The percentage method is the easiest and most common option employers use when disbursing bonuses. With this method, your employer will send you a separate payment just for your bonus. Your employer will also deduct a flat 22% from your bonus for federal taxes. If your bonus is over $1 million, your employer will deduct 22% from the first million dollars and then 37% for any part of the bonus over $1 million.
You don’t actually owe 22% of your bonus in federal taxes. Rather, your actual tax liability depends on your taxable income and filing status. Depending on your specific situation, you may receive a tax refund if your tax withholdings were too high.
Pro: This is the most common method because it’s easy for the employer.
Con: If you make over $89,076 per year, your effective tax rate is higher than 22%, which means you may get a tax bill because not enough was withheld from your bonus.
|
Bonus: |
$1,000 |
|
Federal taxes withheld: |
$220 ($1,000 x 22%) |
|
Take home amount: |
$780 |
The Aggregate Method
With the aggregate method, your employer includes your bonus on your regular paycheck. Using this method, your employer adds your bonus payment to your regular wages and withholds taxes based on the information listed on your W4 form, such as any deductions and tax filing status.
The added money on your paycheck could push you into a higher tax bracket. If this happens, your employer may withhold too much. However, you can obtain a refund for any taxes you overpay.
Pro: This is typically better for the employee because there’s less of a chance a surprise tax bill due to not enough being withheld.
Con: The calculation may be more difficult on the employer’s end, so they may withhold too much, but you can get a tax refund for the amount.
Example of the percentage method:
If you make $5,000 per month broken into two $2,500 paychecks, you’ll make $60,000 per year, putting you in the tax bracket of 22%.
One month, you reach a work incentive and make an extra $1,000. The employer would take the 22% out of $3,500 rather than $2,500. If for some reason, it was a large enough bonus to put you into a higher tax bracket, the employer would withhold the higher percentage.
There are some exceptions to these rules, and these exceptions revolve around if your bonus qualifies as an employee achievement award. In the following instances, you may be exempt from federal income taxes on the bonus:
- The award comes in a form other than cash or a cash equivalent like a vacation or stock options
- The award is personal property that is tangible
- The total value is less than $1,600
Five Ways to Minimize Tax Withholdings from Your Bonus
The goal of most people when preparing for tax season is to get a tax refund and not owe anything when they file. Here, we list some ways to minimize the impact your bonus has on your taxes.
1. Check your Form W-4
As listed in the pros and cons for the two different methods for how bonuses are taxed, the decisions are up to the employer. When you receive your Form W-4 to file your taxes, review it to ensure there were no errors. The last thing you want is for the bonus to be filed in error and push you into a higher tax bracket.
2. Find out if your bonus is taxable
Review the exceptions for what types of bonuses are taxed. If you received tickets to a show or sports event or received a low-value gift, you may not owe any taxes on it. You can also review your state guidelines because they may not have a supplemental tax rate.
3. Know what can be deducted on your taxes
There are many ways to lower your taxable income, and they come in the form of tax deductions. This can take some research, or you can hire a tax professional.
4. Use a tax-advantaged account
A tax-advantaged account is any type of financial account that includes tax benefits, which can include tax-deferred accounts, investments, and savings plans. One of the most common ones is a 401(k) retirement account through your employer. If you contribute your bonus to this account, it can reduce your taxable income while also helping you save for your future.
5. Wait on the bonus
You may want to defer your bonus until the next year if it’s going to put you into a higher tax bracket. This may seem like an odd request to your boss or employer, but it’s common for those who receive large bonuses.
Preparing for Tax Season
One of the best things you can do to minimize your tax burden every year is conduct an annual review of your W4 to make sure the information is correct. For example, check your filing status, dependents, and other adjustments. Your employer uses this information to determine your tax withholdings, so it’s crucial to make sure this information is correct.
It’s important to know how to do taxes yourself step-by-step. Understanding this process can help you minimize your tax burden by making sure you take advantage of all the tax credits and deductions you can. After all, does the IRS catch every mistake? Of course not. This means that if you haven’t done your research, you could miss out on tax deductions that could save you money.
Alternatively, you can have a professional complete your taxes to ensure they’re done right. Credit.com can provide more tax-friendly tips and show you how to get a bigger tax refund.
Source: credit.com