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Wednesday, July 17, 2024

Bonus tax rate 2024: How bonuses are taxed

Bonus tax rate: How bonuses are withheld in 2024

If you've received a bonus at work, congratulations are in order. Employers often hand out bonuses based on performance, company success, years of service, or other metrics of a job well done.

What you may not know is that the IRS considers bonus pay a form of earnings known as supplemental wages, which is subject to a separate tax withholding table than your regular pay. This guide explains what bonuses are, how the bonus tax rate works, and the steps you can take to reduce the tax impact of this extra income.

What is a bonus?

A bonus is a form of compensation employers pay their workers over and above their regular wages. Employers often distribute bonuses near the holidays, at the end of the company’s fiscal year, or once an employee reaches certain goals.

However, employers can disperse bonuses at any time throughout the year, if they choose to offer them at all. In fact, unless it’s explicitly noted in an employee agreement, there’s no obligation for employers to distribute bonuses. Regardless of when you receive it, it’s important to understand the tax implications of receiving a work bonus before your employer distributes it.

How are bonuses taxed?

The IRS considers bonuses as a form of wages, and as such, they're subject to federal taxes, just like your normal pay. However, it’s not just federal tax you have to consider. You might be subject to Medicare and Social Security tax, unemployment tax(es), and depending on where you live, you may also have to pay local and state taxes.

Since your bonus is subject to federal tax, your W-2 (the wage and tax statement provided by your employer by the end of January of the following year) will include this pay in Box 1, which reports the amount of wages subject to federal taxes. This form will be needed to file your 2023 tax return.

You’re likely to notice the biggest difference when you receive your bonus. Since the IRS views bonuses as supplemental income, employers must withhold taxes on bonuses according to IRS regulations for supplemental income, which is a separate withholding calculation than your regular wage or salary pay. How these withholdings affect you personally depends on your overall bonus amount(s), W-4 information, and the method your employer uses to calculate withholdings.

Bonus tax withholding

Generally, your employer can choose between two methods of withholding federal tax on your bonus. When it comes to workplace bonuses, the IRS gives employers two options: the percentage method and the aggregate method. Below is a closer look at these two methods, along with examples and the pros and cons of each type.

The percentage method

The percentage method is a popular method for many employers because it’s the easiest option to calculate. In most cases, when employers disperse bonuses as a separate payment, it typically means they're using the percentage method. 

This method uses a flat rate system. When using the percentage method, employers withhold 22% for taxes on the first $1M and an additional 37% on any portion of the bonus over $1M.

For example, let’s say John receives a $3,500 bonus. His employer will withhold 22% of this bonus for federal taxes. This brings John’s total federal tax withholding on his bonus to $770.

  • $3,500 x 0.22 = $770 federal tax withholding

In another example, Jane receives a $1.3M bonus. Her employer withholds 22% of the first $1M and an additional 37% on the remaining $300,000. This brings Jane’s total federal tax withholding on her bonus to $331,000.

  • $1M x 0.22 = $220,000
  • $300,000 x 0.37 = $111,000
  • $220,000 + $111,000 = $331,000

Advantages of the percentage method

The biggest advantage of the percentage method is that it’s easy to calculate. This is the prime reason so many employers choose this method. It’s also easier for you to determine how much federal tax withholdings will impact your bonus payment.

Disadvantages of percentage method

A flat percentage of withholding may not accurately reflect how these wages get taxed on your return.  For example, if your marginal tax rate is higher than 22% (the flat percentage applied for bonuses under $1M), there’s a possibility that your employer won't have withheld enough taxes, potentially causing a balance due with your return. If, on the other hand, your marginal tax rate is less than 22%, your employer may be withholding more taxes than necessary. In this case, you may have an overpayment, but you’ll have to wait until you file your tax returns to receive a refund. 

Aggregate method

Unlike with the percentage method, employers don’t disburse separate checks when using the aggregate method. Instead, employers combine regular earnings and bonuses into one single check.

This method results in your employer taxing both your standard earnings and bonus payment at the same rate. Your tax withholding rate is based directly on the information on your W-4 form, such as your filing status and dependent information.

For example, let’s say Jim’s filing status is single. He earns $2,500 in regular earnings for the biweekly pay period and receives a $1,000 bonus. His entire earnings for the biweekly period are $3,500.

  • $2,500 + $1,000 = $3,500

Jim’s federal tax withholdings are based on the entire $3,500. When using the IRS 2023 wage brackets, Jim’s total federal tax withholding is $471.

In another example, Susan’s filing status is married filing jointly. She receives monthly earnings of $5,700, as well as a $2,000 bonus. Her entire taxable earnings for the month are $7,700.

  • $5,700 + $2,000 = $7,700

Susan’s tax withholdings are based on the entire $7,700. When using the IRS 2023 wage brackets, Susan’s total tax withholding is $609.

Advantages of the aggregate method

The biggest advantage of the aggregate method is that it typically provides more accurate results. By calculating tax withholdings on your specific W-4 information, there’s a greater chance of using the correct tax rate. However, there's still a chance that you might owe money or receive a refund at the end of the year.

Disadvantages of the aggregate method

This method is often more time-consuming for employers. Although, today’s payroll technology can often handle these calculations automatically. Additionally, by combining your earnings and bonus in one check, it’s possible for you to get pushed into the next tax bracket, increasing the likelihood of over withholding. Ultimately, this factor could result in your bonus being taxed at a higher rate than necessary.

How to reduce the tax impact of bonuses

By now, you may be wondering, “Why are bonuses taxed so high?” It’s because the IRS considers bonus pay to be supplemental income. Therefore, the IRS treats it differently than your standard income. The purpose is to help you save some money back on taxes now, so you don’t face a large tax bill at the end of the year.

No matter which tax withholding method your employer uses, receiving a work bonus could have a significant impact on your taxes. It’s important to know what to do with this increase in earnings and to take proactive steps, if possible, to minimize this impact as much as possible before Tax Day.

Here’s a look at several options that might help you reduce the tax impact of bonuses.

Tax deductions

When filing your taxes, you can choose between using the standard deduction or itemizing your deductions, whichever is higher. Many taxpayers use the standard deduction method. While it’s the easiest method to use, it’s not always the most beneficial.

It’s important, especially when you receive a bonus during the year, to explore your options and determine which deduction method offers the greatest benefit. For example, if you had significant medical expenses, substantial disaster losses, or large charitable donations, itemizing your deductions may be the better option.

It’s always recommended to calculate your deductions using both methods to determine which option works for your specific situation. If you’re using an online tax preparation service or working with a professional tax preparer, they'll likely ask you a series of questions to help you determine which tax deduction method you should use. 

Defer bonus to a new tax year

If you know you're about to receive a bonus and want to reduce your current year's tax liability, you may be able to request that your employer defer your bonus until the following year. There are several factors to consider here. First, by deferring your bonus, you won’t have access to any of the money until the following year. Secondly, if you move up into a higher tax bracket the following year, you may end up with a higher tax liability.

Deferring your bonus to the next year makes the most sense if you think you might move into a lower tax bracket in the following year. For example, if you plan to retire or move to part-time work in the following year, deferring your bonus may make sense.

Additionally, if you think you may be unable to afford the tax implication of a work bonus pushing you up into the next tax bracket, deferring your bonus may make sense. This option won’t lower your eventual tax liability, but it will give you more time to save money to cover these costs.

Contribute to a tax-advantaged account

Another popular option for mitigating tax liabilities is to contribute to a tax-advantaged account, such as a 401(k), traditional IRA, or Health Savings Account (HSA). If you have one of these accounts, consider using a portion of your bonus to make a qualifying contribution.

Since these contributions are made on a pre-tax basis, it can help lower your overall tax liability for the year. Plus, you’ll be saving money in a tax-advantaged account. Keep in mind that these accounts have annual contribution limits. Check to make sure you don’t exceed these limits, or you risk facing unwanted tax penalties.

Review your W-4

One of the first things you can do to minimize the tax implications of a work bonus is to review your W-4. Check to make sure your tax filing status is correct. For example, if you were just recently married but still have your filing status marked as single, you can expect a higher tax withholding if your employer uses the aggregate method. You also want to make sure all additional information, such as deductions, is correct.

If you’re not sure how to adjust your W-4, the IRS tax withholding estimator1 can help. This handy tool allows you to enter all your information and estimate whether your tax withholdings are too high, too low, or just right. Feel free to play around with this tool by trying different options to see what method provides the greatest benefits.

Our take

Receiving a bonus is exciting and often well-deserved, but it's easy to get so caught up in the excitement that you forget about the impact tax withholdings might have on your bonus. Understating how tax withholdings work and how this might impact your bonus can help you prepare.

1 IRS, “Tax Withholding Estimator,” 2023.

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Mike Rock, CPA

Contributor

Mike Rock is a Senior Tax Specialist at Empower. A Certified Public Account (CPA), he is responsible for reviewing and identifying problems, inefficiencies and opportunities related to estate and tax planning for clients.

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