Everyone enjoys receiving a large bonus. It’s one of the greatest feelings you can have at work. One misconception I often hear is that bonuses get taxed at a higher rate than income. Let me explain why you think this and why it is not true.
Bonuses sometimes get taxed higher when you receive them because they are considered “supplemental income.” However, you need to understand that all earned income is taxed the same, but for bonuses the IRS makes employers withhold at a certain rate. If you want to learn more about how you are taxed, check out this article.
Employers withhold taxes from your paycheck in two ways:
- The Aggregate Method – If your bonus is added to your regular paycheck, then they are using this method. Your employer will withhold whatever you put on your W-4. Since you are receiving way more money than usual with this bonus plus your regular salary, more will be withheld from that check.
- The Percentage Method – If your bonus comes on a separate paycheck than your income, your employer is using the percentage method. Here your employer withholds a flat 22% if it’s under $1 million. This is the method used for commission and overtime pay as well. The problem with this method is that many people do not have a 22% effective tax rate. If you are below, you will get it back on your tax return. If you are above, you may end up owing more on taxes.
If your employer uses the aggregate method, it will seem like you are getting taxed heavily because of the combination of your bonus and your income. If you make $5,000 a paycheck plus a $5,000 commission, it is seen as you making way more money than normal, pushing you into a higher tax bracket even though you aren’t really in a different tax bracket. This method helps ensure you withhold enough, but oftentimes has you withhold extra that you will end up getting back later.
If your employer does the percentage method, they could be overwithholding if you are in a lower tax bracket. However, it could also result in underwithholding if you have a higher income. You need to be mindful of this, especially if you have a higher income since may owe more tax than is withheld.
There are a few ways to help mitigate the tax impact of your bonus:
- Contribute to your 401(k) – this will help lower your tax bill. You can even go in before this paycheck and increase how much you put in your 401(k) to help even more. Also, some companies allow you to in advance set higher contributions to bonuses alone.
- Contribute to your HSA – if you aren’t set to max it out already, you could increase HSA contributions around the time of this paycheck to limit your tax liability.
- Take advantage of all the tax deductions and credits at your disposal, but remember, if you are in lower tax brackets, paying tax today may make sense instead of deferring it.
So at the end of the day, no, your bonus does not actually get taxed more heavily than your income. It is all seen as the same income and taxed at the same rate. You just may withhold extra or not enough when your bonus is paid out.
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Disclaimer: none of this is advice, it is just for informational purposes. Talk with your financial planner before implementing any of these strategies.