What Is the Bonus Tax Rate?
It’s great to have bonus income, but the net amount can be surprisingly less than you expect. Laura explains how your bonus is taxed and different types of income that get singled out for special tax withholding. Find out how getting a bonus affects contributions to workplace retirement accounts like a 401k or 403b.
Laura Adams, MBA
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What Is the Bonus Tax Rate?
If you’ve been fortunate enough to get a bonus at work, you probably experienced joy and confusion at the same time. It’s great to have extra income, but the net amount you see in your paycheck can be surprisingly less than you expect.
In this post, I’ll explain how your bonus is taxed and different types of income that get singled out for special tax withholding. We’ll also cover how getting a bonus affects contributions to workplace retirement accounts like a 401k or 403b.
Free Resource: Laura’s Recommended Tools—use them to earn more, save more, and accomplish more with your money!
What Is Supplemental versus Regular Income?
There are a variety of situations that might qualify you for a bonus at work. They’re typically tied to performance, such as achieving company goals, accomplishing individual goals, or hitting a combination of both metrics.
For instance, you might receive salary plus a 20% bonus each quarter. Ten percent might come from meeting the performance objectives of your job and the remaining 10% would be paid if the company hits its overall profit target.
An employer might offer you a signing bonus to entice you to leave your current company and take a new job. Or you could receive a retention bonus if you stay with the same company for a certain period of time during an important transition, like a merger or acquisition.
If you relocate for a job, you might be paid a moving bonus that covers some or all of your estimated moving expenses. And if you get fired or retire early, a bonus might be part of a severance or retirement package that also includes unused vacation pay or other benefits.
These are some examples of income that the IRS considers “supplemental wages” because they’re paid in addition to your regular wages. Your employer is required to withhold taxes on supplemental income differently than for your ordinary income.
See also: How to Pay Less in Taxes (Part 1)
What Is the Bonus Tax Rate?
The major point to remember from this article is that bonus income is ultimately taxed the same as your regular pay. The special treatment of withholding for bonus income is to ensure that you don’t have a surprise liability at tax time.
You may be thinking then why does it seem like I end up paying more tax on my bonuses? Keep reading and I’ll explain what happens.
Once the overage is paid back to you as a tax refund, you’ll end up paying the same amount of tax on your supplemental wages as for your regular wages.
Bonus payments are subject to Social Security and Medicare taxes (just like regular wages), but they have different federal and state withholding practices. Your employer can handle the withholding in two different ways: using a percentage method or an aggregate method.
- The percentage method allows an employer to withhold tax from your bonus at a flat rate of 25% and issue payment separately from your regular pay. This is the most straightforward and simple method. However, in my experience it’s not the most common.
Note: If you’re really fortunate and get 7-figure bonus, the IRS withholds amounts above $1 million at 39.6%, in addition to 25% of the amount below $1 million.
- The aggregate method is when an employer withholds tax by combining your bonus with your most recent regular pay amount, and uses a tax rate found in withholding tables, which is based on the information you submitted in Form W-4, Employee’s Withholding Allowance Certificateopens PDF file .
Let’s say you’re single and make $50,000 a year. Your net withholding for federal taxes typically would be about 15% per paycheck. But if you got an annual bonus of $5,000, the aggregate method calculation would result in 27% withholding from that payment.
However, this higher-than-normal withholding will be credited to you for the year. So when you file your taxes, any amount you’ve paid that exceeds what you actually owe comes back to you as a tax refund.
In other words, your bonus may be temporarily subject to high withholding, but it won’t be taxed at a higher rate than your ordinary income for the year. Once the overage is paid back to you as a tax refund, you’ll end up paying the same amount of tax on your supplemental wages as for your regular wages.
So while it may seem disappointing to take home a smaller net bonus than you’d like, the upside is that you won’t have to pay extra on tax day. In fact, you’ll likely get a larger tax refund than you expect.
Related article: What Is the Self-Employment Tax?
Can You Avoid Higher Withholding on Bonus Income?
But what if you’re counting on a higher net bonus payment? Assuming your employer uses the aggregate method for withholding calculations, you can adjust your withholding by filing an updated Form W-4opens PDF file with your employer.
The W-4 is how an employer knows how to calculate your withholding based on your tax filing status and number of dependents or “allowances.” The higher your allowances, the less your withholding.
Ultimately it’s up to you to manage your personal finances so you can pay the tax you owe each year. If you have too little tax withheld during the year, you’ll have to make up the shortfall by the tax filing deadline.
For instance, if you’re married and have one child, you’d typically claim one allowance. But if you want less tax withheld, you could claim 5 allowances instead. This isn’t lying—nor does it apply to your actual tax return, where you must indicate the correct number of dependents.
If you’re concerned about bonus withholding, be sure to speak to your payroll administrator at work. If you decide to update your W-4, submit it at least 30 days before your bonus is paid so your payroll department has enough time to process it.
Ultimately it’s up to you to manage your personal finances so you can pay the tax you owe each year. If you have too little tax withheld during the year, you’ll have to make up the shortfall by the tax filing deadline.
If you do file an updated Form W-4 with more allowances than normal to reduce tax withholding on a bonus, don’t forget to reverse it by submitting another W-4 after your bonus is paid. Otherwise you could end up with a big tax bill that you’re not prepared to pay at the end of the year.
See also: 5 Ways to Pay a Tax Bill You Can’t Afford
Bonus Income and Your Retirement Contributions
I received a question from Steve E. about how bonus income may relate to your retirement contributions. He says:
“Thank you for the great Money Girl podcasts. Is there any financial benefit to taking retirement contributions for my 401k from my bonus, instead of from my regular paycheck—or does it not matter which part of my compensation the contribution comes from?”
This is a great question because on the surface it might seem like reducing bonus income that’s subject to higher withholding would be more beneficial. But that’s not the case.
Since your bonus income is eventually taxed the same as your regular income, taking retirement contributions from either type of income has the same result. Traditional, pre-tax contributions to a retirement plan allow you to cut taxes by reducing your taxable income in the current year.
Don’t forget that your retirement contribution will typically be deducted from your bonus income, unless you elect to change it ahead of time. For instance, if 10% is deducted from each of your regular paychecks for a 401k contribution, 10% will also be deducted from your bonus payment.
For 2016, you can contribute up to $18,000 to an employer-sponsored retirement account (like a 401k, 403b, or 457 plan). If you’re age 50 or older, you can make $6,000 in additional “catch-up” contributions, for a total of $24,000. Saving more of a bonus can boost your retirement savings so you reach your goals faster.
So consider increasing your retirement contribution ahead of a large bonus payment. Just keep an eye on your total contributions so you don’t exceed the annual allowable limit for the year.
See also: Take a Personal Money Day to Accelerate Your Success
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.