How Do Taxes Work With Bonuses?

Bonuses, frequently given at the end of the year, are a popular “thank you” for a job well done, and smart business owners know they can build loyalty, helping retain the most productive employees. However, both owners and employees often misunderstand how taxes work with bonuses, leading to confusion and frustration. Fortunately, with some education and preparation, the situation can work out for everyone.

In brief, bonuses are income and are subject to relevant federal and state taxes — including FICA. Businesses must enter any bonuses on their employees’ Form W-2s. However, when it comes to federal income taxes, the withholding is different from the regular paycheck.

The IRS allows two withholding methods. If the bonus is separate from the regular paycheck, an employer will typically use the percentage method, which means the 22% rate applies to everyone. This is an easy system for the employer. However, employees who are in a higher bracket may thus find that too little was withheld and they will owe money. Those in a lower bracket may find too much withheld, leading to a refund.

The aggregate method is more complex for the employer but may lead to a more accurate withholding: The employer combines the bonus into a regular paycheck and calculates the withholding as usual, based on the employee’s Form W-4. Of course, employees are sometimes careless about updating this form, which may mean too much or too little is withheld. So it’s always a good idea for companies to remind employees to review their Form W-4 information annually.

Still more special rules

Those are the basics, but other special rules may apply to further complicate the situation:

1. Extra-large bonuses. In some businesses, top employees may receive a seven-figure bonus. In this case, a higher withholding will apply.
2. Incentive plans. These are common in the automotive industry and in rare exceptions are listed on Form 1099-MISC instead of Form W-2. No taxes are withheld, but employees still have to report this as income.
3. Delayed bonuses. Some employees may be better off from a tax perspective by taking a bonus in the following year. The company can agree to do this, but this doesn’t eliminate any tax; it just postpones it. Recipients should work with a tax professional to make sure this is a prudent strategy.
4. Sending the bonus straight to the retirement plan. Employees who haven’t reached the maximum contribution limit can put some or all of their bonus into a 401(k) plan, for example, reducing taxes and reaching a savings goal faster.
5. Making sure a bonus really is a bonus. Although money is taxable, other items of value, although called “bonuses,” may not actually be taxable. Seasonal gifts, occasional sporting or concert tickets, and various minor fringe benefits may not be subject to tax. The line can be thin, however, so be careful.

The bottom line? Both companies and employees should work with tax professionals so bonus time is a happy time for everyone.