It's getting close to the end of the year, which means that companies are probably thinking about giving out holiday bonuses. If you intend to give your employees more than a membership to the jelly-of-the-month club this holiday season, there are a few things to bear in mind about the taxation of bonuses.
Bonuses and other forms of additional compensation like severance pay and commission are considered "supplemental earnings" rather than "ordinary and necessary" income.
This is where most people get lost, by the way.
The Internal Revenue Service treats bonuses the same as salary, but your employer has the option of using either of two techniques to determine how much to withhold from your pay. Paycheck calculations are left to the discretion of the company. How the figures are worked out affects two things: the amount of the bonus that makes it onto your paycheck and the amount of taxes you owe for the year.
The IRS permits using either the percentage technique or the aggregate method to determine how much money should be withheld from bonuses and other forms of additional income.
Bonuses fall within the IRS's definition of "supplemental pay," which includes almost all forms of remuneration beyond base salary. The Aggregate Method and the Percentage Method can be used to calculate the tax due on supplemental income and regular income.
The bonus and base pay are added together and then taxed as a single lump sum. As a result, the employee may see a rise in the amount of taxes deducted from their paychecks, as they will temporarily fall into a higher tax rate.
Employees are generally aware of this tax effect since they frequently voice surprise at the size of the tax deduction taken from their bonus. This is why the Internal Revenue Service (IRS) allows a second, percentage-based method of taxing bonuses to be used.
If you choose this approach, 22% of your bonus will be withheld to cover federal income taxes. It's as easy as that. This allows businesses to withhold taxes at a consistent rate and prevents those with higher incomes from having an unfairly disproportionate share of their pay subject to taxation.
If you've done a good job, getting a bonus may feel like a reward you truly deserve. Because, really, who doesn't want some praise and more cash to spend toward a reward for themselves? When you receive your paycheck, you may be taken aback and wonder, "Wait a minute - this gets taxed, too?"
Indeed, bonus income is subject to taxation. And how they're divided up is influenced by a number of factors, including the technique your company uses to determine such things.
Learn about the two ways in which your employer might determine your withholding and how you can lessen the financial impact of a bonus in this helpful guide.
A bonus is an extra payment given to an employee by their employer. A bonus is a one-time payment in addition to regular compensation for a worker.
Bonuses are typically given out during specific times of the year (such as the holidays) or are a standard part of particular pay structures (e.g., for hitting a quarterly sales goal). Bonuses can also be annual, merit, referral, sign-up, and retention based.
Any bonus you get counts as income for tax purposes.
Short-term means that your employer will deduct tax money from your bonus check. The fun doesn't end there, though; you may also have to pay taxes to your state and Medicare and Social Security (referred to as FICA taxes) on the bonus.
Your annual salary will increase as a result of the bonus. Box 1 of your W-2 will reflect your year bonus income plus any other income you earned.
The bonus you get will be subject to taxation at the same rate as the rest of your income when you file your annual taxes. Your employer will voluntarily withdraw a portion of your salary throughout the year to cover estimated tax payments. In the event that you have withheld enough money, you will not be responsible for paying any taxes. You may owe taxes or receive a refund based on the amount of money you withheld from your paycheck.
In light of your newfound knowledge of the many forms of bonus taxes that must be withheld, it's imperative that you have a firm grasp on the formulas that will guide you in arriving at the correct amounts. After all, as was said, the method through which bonuses are paid affects the amount of tax withheld from an employee's paycheck. The percentage approach is used in the first scenario, while the aggregate approach is used in the second.
Assume, for the sake of argument, that your firm is headquartered in a city in Colorado that does not impose a municipal bonus tax, and that you pay an employee a one thousand dollar bonus, to be delivered by cheque or direct deposit, in addition to their normal paycheck. Here, the percentage technique is used to determine the federal bonus tax.
Consider the federal bonus tax of 22% as an example:
Federal bonus taxes on $1,000 are $220 (1,000 x 0.22).
FICA tax withholding must then be determined.
FICA taxes on a salary of $1,000 are $76.50 ( $1,000 x 0.0765% ).
The final step is to figure out how much of a percentage of your bonus should be withheld for the state of Colorado's bonus tax (4.63%):
Colorado's share of the prize is $46.30 ($1,000 x 0.0463).
Here's what you get if you sum up all the potential tax bills associated with bonus payments:
Total bonus taxes equal $342.80 ($220 + $76.50 + $46.30).
Since this is the case, the bonus payment you make to the worker will be $657.20 rather than $1,000.
Assume once more that your company is based in a part of Colorado where there is no state or local bonus tax. The aggregate technique is used to determine federal bonus tax if the same $1,000 bonus is distributed over the course of several paychecks rather than as a single lump sum.
The federal bonus tax rate of 22% does not apply when using the aggregate technique. Instead, the amount of tax deducted from the bonus payment is determined using the usual federal income tax tables. If an employee who normally makes $6,500 per month receives a $1,000 bonus, he or she will receive $7,500 total for the month.
This means that instead of making $78,000 per year, the employee will only make $6,500 this month, bringing their effective annual income down to $73,500. It's actually $90,000 (12 x $7,500). The employee's effective annual compensation after the bonus amounts to $90,000, putting them in a higher federal income tax bracket and subject to a tax rate of 24%, as opposed to 22% on their ordinary $78,000 annual income (assuming they are single filers who are not heads of household). At this rate, you will deduct taxes from the bonus you are giving.
In light of this, the $220 in federal bonus tax that would have been withheld in the prior case is not being withheld from your paycheck. A breakdown of the math is as follows:
$1,000 x 0.0024 = $224
All state and federal bonuses and FICA taxes are computed in the same manner.
Take note that the aggregate method needed much more effort for a $4 rise in federal bonus tax than the percentage method. Many companies utilize the percentage technique instead of the aggregate method for calculating bonus taxes because the latter might lead to larger tax withholding and is more time-consuming to calculate.
You can forget about using a percentage to calculate pay if you also pay bonuses. Bonuses should be paid out of the regular payroll system to reduce the administrative burdens.
A bonus is considered earned income on par with wages or a salary and is subject to the same tax rate. Some workers may complain that a larger share of their bonus is going to taxes than their normal wage. Even though there appears to be a conflict here, both statements are true. You, as an employer, need to be aware of the tax implications of offering bonuses. This may help you clarify any doubts or concerns your employees may have concerning the taxes they must pay on their bonus checks.
Companies commonly use bonuses to motivate their staff and recognize those who have consistently delivered above and above. It's common practice since bonuses have been shown to be effective at attracting new employees, keeping existing ones, and inspiring a sense of personal achievement in their work. In contrast to the employee's regular income, the bonus is given out of the company's own funds. Bonuses are considered additional wages by the IRS, just like commissions.
You're possibly confused about the distinction between a bonus and a commission. Let me explain. Commissions are a form of sales-based payment. If a salesperson makes $1,000 in a given week and is paid a 2 percent commission, she can expect to see $20 more in her next paycheck.
Examples of supplemental income include a payout for accumulated sick leave, payment for severance compensation, payment for overtime worked, payment for retroactive pay increases, awards, and prizes. Extra compensation is subject to the same taxation rules as a normal salary. Supplemental wages are treated the same as normal wages for tax purposes and are subject to the same tax rates and withholding requirements. Bonuses and other forms of extra pay are taxable at the federal, state, and municipal levels and subject to Social Security and Medicare contributions.
Just like regular paychecks, bonuses are subject to payroll tax withholding by employers. Some exceptions to the normal IRS guidelines do exist, though. Companies can use either the aggregate or the percentage method to determine the amount of additional wage withholding taxes to deduct from employees' paychecks. If your company employs the aggregate technique, your bonus will be added to your base pay. As a result, payroll taxes must be added to the total.
The employee may be unprepared for the higher rate of payroll tax withholding. This is because the highest federal tax rate applicable to the employee's total remuneration will be withheld from any additional pay the employee receives.
Employers use the percentage technique for calculating bonus pay taxes because it is straightforward. Every dollar of a bonus is subject to the same tax rate. The "bonus tax rate" for 2019 is 22%. The bonus tax rate is relevant exclusively for the purposes of payroll tax withholding and has no bearing on the employee's tax burden. All bonuses over $1 million per year are subject to a 37% surtax.
Payroll processing is more reliable if done with software that includes a bonus tax rate calculator. However, the % method is straightforward and easy to use. The percentage will be calculated by multiplying the total bonus by 22. To figure out your Social Security tax, multiply your gross amount by 7.65 percent.
Withhold 1.45 percent of the employee's pay instead of the full Social Security tax if their yearly earnings have already exceeded the annual maximum for withholding. Deduct 0.9% for the Additional Medicare tax if the worker's salary is over $200,000.
Let's pretend you give one of your workers a $2,000 bonus. Federal income tax withholding amounts to $440, calculated as $2000 times 22%. Multiply $153 by 7.65 percent to get the amount you owe for Medicare and Social Security. As a result of this deduction, the worker will get $1,407 (minus federal, state, and maybe municipal income taxes).
Some of a worker's normal paycheck doesn't get taxed when taxes are withheld because of exemptions and withholding allowances. In addition, the maximum federal income tax rate is currently 10% or 12%, affecting many workers' paychecks. The tax rate on bonuses is higher, at 22%, and it's applied to the full amount, no matter how small. This presumably explains why bonus income is taxed more heavily than salary.
Working diligently throughout the year to assist your firm to achieve its annual goals merits a reward, and you have certainly earned that bonus. However, bonuses are subject to income taxes because they are considered part of your annual salary. Find out how much tax you'll owe on your bonus and how to minimize it by reading on!