If you’re like most people, you’re thrilled to receive a holiday or end of year bonus from your employer. When you spend a few minutes with your calculator, though, your bonus may suddenly seem less attractive. If you’re not careful, you can lose more than a quarter of your bonus in taxes, and you may end up in a higher tax bracket to boot. Take the time to do the calculations carefully before you decide to accept a bonus from your employer. This information will make it easier to budget the money you’ll be receiving if you accept the bonus.
How Does the IRS Identify Bonuses?
Before you make a decision about accepting your bonus or turning it down, it’s important that you understand how bonuses are taxed by the Internal Revenue Service (IRS). The IRS sees bonus income in a separate income from your wages. A bonus is classified as “supplemental” income and is taxed at a higher rate. There are two methods for calculating the tax for a bonus, and the amount you pay will depend on the method your employer uses.
Which Method of Taxing Bonuses Does Your Employer Use?
While it’s easy to blame the tax man for the amount of your bonus that goes to the IRS, the actual amount you pay will depend on the withholding method your employer has chosen. The percentage method is significantly easier for the employer, and is the method most commonly used. Your total tax, and potentially your tax bracket, will therefore depend on your employer’s choice. This makes it especially important that you learn how a bonus will be taxed before making a decision about whether or not to accept it.
Percentage Calculation Method: If your employer selects the percentage method for calculating bonuses, any bonus you receive will be taxed at the supplemental rate of 25%. This means that the amount of your bonus will be kept separate from your other earnings. Most employers use this method as it makes their calculations simple.
Aggregate Calculation Method: Employers who choose the aggregate calculation method add the amount of the awarded bonus to the employee’s last regular check. They then calculate the withholding amount for the sum of both amounts and subtract what was already withhold from the last paycheck, then withhold the rest from your bonus amount. The total may be more or less than 25%, as you are taxed on the combination of your bonus and your income.
Make the Decision That’s Right for Your Wallet
When you’re offered a bonus, you’ll need to carefully evaluate the options available to you, and make the decision that’s right for your wallet. For example, if an end of the year bonus will put you into a higher tax bracket for the current year, but you expect to earn less next year, you may be able to ask your employer to delay awarding the bonus until after the first of the year.
No matter what choice you make, you can expect to lose at least 25 percent of your bonus back to the IRS. However, you may be able to avoid ending up in a higher tax bracket as well. Do the math carefully and, if necessary, speak with your accountant before making a final decision.