Tax Issues with Bonuses?

A while back we had a candidate receive a job offer that caused him some concern. He was perfectly fine with the compensation amount but was a little troubled that a portion was going to be a guaranteed bonus. His concern was that he had heard that bonuses get taxed at a much higher rate than actual salary.

It appears he was confused about how the federal government deals with?withholding?taxes on bonuses. Our federal tax system can be confusing, so his misunderstanding was understandable. This confusion became apparent when we went to the internet and found that many other people have been misinformed about taxation on bonuses, causing lots of bad info to spread. We even found that?Fidelity's website?was worded in a confusing and misleading way. Let's try to clear that up if you were wondering about this same thing yourself.

Bottom Line: at the end of the year, the federal government taxes your bonuses at?the same rate as your salary. When it comes time to file your taxes, your bonuses should be lumped into?Line 1 of your W-2?along with your normal wages. Here's where the confusion comes into play: the way your employer calculates your?income tax withholding?on your regular paychecks can be different for bonuses than for normal wages.

Simply put, your employer can use one of two methods to calculate withholding amounts: the?percent method?or the?aggregate method. Using the percent method (which is the simplest and most common), your bonus is treated as supplemental income subject to a flat 22% withholding rate (with one exception, explained below). So depending on your actual tax bracket, that 22% rate may be higher than the percentage used to calculate the withholdings on your normal wages.

Here's a quick example. In this case, I'll use a single head of household earning $100,000 a year. If the person's entire income was in salary, the tax tables say their withholdings would be approximately 17%. This amount could be higher or lower, depending on the number of dependents claimed. But if $10,000 of that $100K was attributed to a bonus, the withholding on the bonus would be 22% of the $10,000 instead of 17%.

You may be wondering about the exception that we mentioned above. It only applies to those super high earners whose bonus exceeds $1 million. In those cases, the withholding for the portion?above a million?is a whopping 37%.

The other technique, the aggregate method, can have a slightly worse impact on your take-home pay. In this case, let's say that your annual salary is $72,000 ($6,000 monthly) and you receive an additional $10,000 bonus lumped into one of your monthly paychecks for a total of $16,000 for the month. Under the aggregate method, your withholding for the month is based on annualizing the entire $16K. Or in other words, your withholding is based on an assumed $192,000 per year (since $16,000 over 12 months = $192,000). Therefore, the withholding would be based on you being in a 32% bracket of a $192K earner instead of the 22% bracket for someone earning $72,000 per year. If you received that $10,000 bonus each month (unlikely), then no big deal since it evens out. Yet even though that bonus may be something you receive just once or twice during the year, your withholding amount could be much larger since this method assumes that the $16,000 is a recurring monthly amount.

Again, in either case, your annual taxes should be the same, no matter the method (percentage or aggregate) or the type of pay (bonus vs. salary). It's the "pay me now or pay me later" conundrum. Does that mean you shouldn't accept a job offer because of the inclusion of bonuses instead of a higher salary? We think not, seeing as those bonuses may increase your earning potential significantly. But you will want to plan for how it may affect your monthly take-home pay and adjust your withholdings accordingly.