Here's why your bonus is taxed so high
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- If you receive an annual bonus, you may be surprised to see how much is taken out for taxes.
- According to an accountant, that's because your bonus is considered "supplemental income" by the IRS, and treated differently at tax time.
- Taxes will be withheld from your bonus according to the percentage method, which is used if your bonus comes in a separate check, or the aggregate method, used if your bonus is tacked on to your regular pay.
- If you're receiving a large bonus, you may be able to offset some of the taxes with unrelated deductions, like increasing your retirement contributions or making a charitable contribution.
- This post has been reviewed for accuracy by Thomas C. Corley, CPA.
- See Business Insider's picks for the best tax software »
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At one of my first jobs, I got an annual bonus.
I don't remember the numbers.
What I do remember, however, is how surprised I was to see how much less I received than the number I was told at my end-of-year review. Thanks, taxes.
I know I'm not the only one mystified by the case of the missing bonus, so I reached out to Certified Public Accountant Lisa Greene-Lewis of TurboTax to find out why end-of-year bonuses seem to be taxed at such a high rate.
Why bonuses are taxed so high
It comes down to what's called "supplemental income." Although all of your earned dollars are equal at tax time, when bonuses are issued, they're considered supplemental income by the IRS and held to a higher withholding rate.
It's probably that withholding you're noticing on a shrunken bonus check. Employers take taxes from your check in one of two ways:
The percentage method. This is the method your employer will use if, like I did, you receive your bonus money in a check separate from your paycheck. Your company simply withholds tax at a flat 22%, to keep things easy on their end.
The aggregate method. This is the method your employer will use if your bonus is added on to a regular paycheck. Your employer will withhold tax from your bonus plus your regular earnings according to what you shared with your employer on your W-4. Because you're receiving more money than usual, your employer will withhold more money than usual.
In fact, the IRS provides a handy calculator that figures out the tax withholding on your income, so you can brace yourself ahead of time. Greene-Lewis says that in some cases, depending on your income and tax rate, you might actually get some of this money back in the form of a tax refund.
You may be able to offset a large bonus with tax deductions
If your bonus is only a few hundred bucks, there isn't much you can do about the taxes. If you'll receive a considerable amount of cash, though, you have a few options.
"Maybe you can increase your retirement savings," Greene-Lewis suggests, "or you can donate to your favorite charity and get a deduction there. If you own a home, you can maybe prepay your mortgage and get a bigger deduction, or prepay your property taxes." While none of these options allow you to keep more money from your bonus, they do provide tax breaks that could offset the tax on your bonus.
While some people get their bonuses in January or February, others receive them around the holidays. "A lot of time employers like to pay holiday bonuses in December because they're able to write that off if their books close December 31," Greene-Lewis explains.
If that's the plan for you, and your bonus is big enough to push you into another tax bracket, you can also ask if your company will defer the payment of your bonus to the new year.
This comes in handy if you expect your income to decrease in the new year, or if you expect your deductions to increase substantially enough to offset the taxes - for example, if you're planning to buy a house.
While you might think, logically, that employees could be better served tax-wise by gradual bonuses paid over a series of paychecks or by a simple raise that tacks on some extra money year-round, Greene-Lewis says that a company's ability to pay bonuses is determined between the time it finishes up its accounting for the year and when it officially closes its books, and in some cases, those bonuses have to be paid before that year is closed. Because a company doesn't know how much it can afford to pay until the last possible minute, employees end up getting lump sums.
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