When you work hard all year to help your company achieve its annual goals, you deserve a reward. As a result, you've earned a well-deserved bonus. However, bonuses are treated as income for the year, and you have to pay income taxes on them. Whenever you receive a bonus, the IRS will expect a cut. Your bonus will generally be taxed whether you receive it in cash, gift cards, a vacation, or some other benefit.
How are bonuses taxed?
The Cash Bonus
The most common means by which employers deliver end-of-year bonuses is through cash or checks. Your employer will add the bonus to the W-2 you receive in January if they do this.
The tax treatment of cash bonuses is similar to that of wages. On line 1 of your tax form 1040, you will report the bonus as wages. It is best to hire a tax professional to assist you in this.
Non-Monetary Gift Bonuses
The gifts you receive from your employer on a regular basis - such as headphones, a holiday sweater, or even tickets to a theater or sporting event - are likely to not be taxed. A gift falling into this category is known as a "de minimis fringe benefit" and is not taxable.
De minimis fringe benefits are generally determined by your employer. Generally, de minimis fringe benefits are rare or infrequent and have a small value that makes accounting for them unreasonable or impractical.
Gifts of cash or cash equivalents are not subject to the de minimis fringe benefit rules. Therefore, any gift of cash received by an employer is subject to the rules discussed above in the "cash bonuses" section.
Gift Card Bonuses
Gift cards are often presented by employers during the holidays or after an important sales goal has been reached. Gift cards are considered equivalents to cash by the IRS, and are taxed the same way as checks or cash.
Signing Bonus Tax
You may receive a sign-on bonus when you begin work at a new company. If paid in cash, signing bonuses would fall in the above category.
Bonus Tax Rate Brackets
Unlike income, bonuses are not simply added to your income and taxed at your marginal tax rate. Rather, your bonus is considered supplemental income and is withheld at a flat rate of 22%.
Tax on a Bonus Equaling Less Than $1 Million
Bonuses less than $1 million are taxed differently depending on whether they are included in your paycheck with other wages or received separately.
If your bonus is paid along with your typical wages and not separately identified, the bonus will be taxed the same as your usual wages. The effect of combining the two could be that your tax withholding percentage for that tax period would increase as if you would receive that amount each paycheck for the rest of the year.
A bonus that is paid or identified separately can be taxed at a flat rate of 22%.
In either case, the paying of supplemental wages will affect your withholding for that period, so be sure to prepare.
Suppose you get a $5,000 bonus for the year. You will probably be required to withhold $1,100 in federal taxes to be sent to the IRS
$5,000 x .22 = $1,100
Tax on a Bonus Exceeding $1 Million
A rate of 37% will apply to any excess wages in excess of $1 million.
This means that a portion of your bonus will be taxed at a higher rate. You will be taxed 22% on the first million, and 37% on bonus funds above that.
If you received a bonus of $2 million, you would pay $590,000 in federal taxes
$1,000,000 x .22 = $220,000 tax on first million
$1,000,000 x .37 = $370,000 tax on second million
$220,000 + $370,000 = $590,000 total tax
Supplemental Pay vs. Regular Pay
Your bonus will be taxed as regular income if your employer delivers it as part of your regular paycheck. It's taxed as supplemental income if it's delivered with a separate check. Supplemental income is taxed at a flat rate of 22% while regular income is taxed at your normal rate.
Bonuses paid to Business Owners
You cannot deduct bonuses paid to yourself or your business partners if your business is a sole proprietorship, partnership, or LLC. The IRS considers sole proprietors, partners, and LLC members to be self-employed.
Businesses can claim bonus deductions only if they file like a corporation, including S corporations, C corporations, and LLCs that have elected to be taxed as corporations.
How Bonuses are Withheld from Your Taxes
Although bonuses are subject to income tax, they are not simply added to your income and taxed at the top rate. Instead, your bonus will be considered supplemental income, subject to federal withholding at a 22% flat rate.
Bonuses may also be subject to state taxes, although the withholding rate will vary by state.
The same way your employer withholds money from your regular paycheck to prepay taxes, it also withholds money from your bonus check. The money is sent to the IRS on your behalf. This process is called withholding.
If you receive a bonus, your employer may calculate your tax withholding in one of two ways: either by percentage or by aggregate.
The percentage method, also called the flat rate method, is an easy way for employers to calculate taxes on bonuses. As a result, you will typically receive more money than you would otherwise.
If your employer taxes your bonus using the percentage method, it must separate your bonus from your regular pay.
These will be labeled as supplemental wages, and will be subject to a 22 percent tax rate. Bonuses and any supplemental wages up to $1 million during the tax year will be subject to that rate. When your bonus totals more than $1 million, any amount over that amount will be withheld at a rate of 37 percent.
Occasionally, employers pay bonuses on top of regular wages. As a result, your employer must calculate the initial tax withholding on your bonus using the aggregate method. As a result, the employer has to figure out tax withholdings and can possibly deduct more from your bonus.
When you calculate your tax withholding from your bonus using the aggregate method, your regular income tax rate is used. Your tax bracket determines your withholding rate. The initial tax withholding you receive is often higher when wages and bonuses are combined this way.
If your bonus is considered an employee achievement award, then you are exempt from income tax witholding. If you meet the following conditions, you may be able to avoid paying federal income taxes:
- Bonus items are not cash, cash equivalents (such as gift cards or money orders), tickets to events, vacations, stocks, bonds, or other prohibited items.
- The bonus is tangible personal property.
- The value of the bonus does not exceed $1,600.
How to report a bonus on your taxes
Despite the fact that cash bonuses may be treated differently from other income, they should still be reported on your W-2.
In cases where your bonus is reported on a 1099-MISC, you should request that the 1099-MISC be canceled and a corrected W-2 be issued.
If your employer does not provide you with a tax correction, you can still properly report your bonus for tax purposes. You must report the wages shown on the 1099-MISC on line 1 of your Form 1040 and supply Form 8919 to report uncollected Social Security and Medicare taxes.
How to avoid taxes on a bonus
Generally speaking, there are two main ways to manage the taxes you owe on a bonus. One way is to reduce your income. The other is to increase your deductions.
If you ask your employer to delay paying the bonus until January, you may be able to save on taxes.
In cases where you expect to earn less next year, and your bonus would push you into a higher tax bracket this year, this strategy makes sense. Even if you are still in the same tax bracket, you benefit from delaying your tax bill by a year.
Choose a Different Bonus Delivery Method
If your employer includes your bonus in your regular paycheck, it will be taxed as regular income. If it's delivered with a separate check, it's taxed as supplemental income. Supplemental income is taxed at a flat rate of 22%, whereas regular income is taxed at your normal rate.
When compared to adding an amount to your regular paycheck, having the bonus delivered as supplemental income is usually less expensive. It may be possible to get your employer to pay you so that the bonus is considered supplemental income. Your specific circumstances will determine which method will lead to lower taxes.
Make a Retirement Contribution
A tax-deferred retirement account is one of the best ways to reduce taxes on a bonus. These accounts can be either 401(k)s or individual retirement accounts (IRAs). When you make a donation to a retirement account, your taxable income is reduced, so you will owe less in taxes.
Depending on the type of retirement account, there are different limitations. In addition, they can change each year.
Note: you cannot get a deduction for a contribution to a Roth IRA.
Contribute to a Health Savings Account
Health savings accounts (HSAs) may be available to people who have high-deductible health plans. When you contribute, your gross income is reduced by a certain amount. As a result of the tax-free nature of withdrawals from an HSA, it's one of the best ways to manage taxes. You can only contribute a certain amount to your HSA.
Donate to Charity
Contributing to a charity can reduce your taxable income if you itemize your deductions rather than take the standard deduction. If you plan to make donations for two years, consider bunching them this year.
The IRS allows you to donate up to 50% of your adjusted gross income to a qualified charity, which includes nonprofits that promote literacy, education, amateur athletics, and religious charities.
Pay Medical Expenses
Using the bonus to pay for medical or dental expenses not reimbursed by insurance can reduce your taxable income if you itemize deductions.
However, unreimbursed medical and dental expenses may be deducted only if they exceed 10% of adjusted gross income.
Request a Non-Financial Bonus
Changing a financial bonus to a non-financial bonus may reduce your taxes on your bonus to zero. Working from home or working flexible hours are examples of non-financial incentives.
Non-financial bonuses are not all tax-free, however. A bonus like extra paid vacation time can be taxed as a financial bonus, for example.
Lowering Your Tax Withholding on a Bonus
How can you lower the amount of taxes withheld from your bonus? Have your employer separate your bonus from your paycheck. You can then determine if your employer will calculate your tax withholding at the flat rate of 22 percent that the IRS allows for supplemental wages.
You may receive a refund for overpayment of taxes if the tax withholding on your bonus is higher than necessary. In contrast, if too little money was withheld from your income throughout the year, you might owe the IRS.
Taking a look at your W-4 withholdings can help you reduce your chances of owing the IRS money.
Helpful Resource: How to Fill Out Your W-4
Taxes are a tough way to give up your hard-earned bonus. However, it is also a good reminder to consult a tax professional about ways you may be able to offset the taxes you pay on the bonus. It may be a good idea to consult a tax professional if you receive a large bonus or if your financial situation changes.
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