Why Is My Bonus Taxed So High? Understanding Bonus Taxation

Bonuses are always a welcome addition to your income, whether it’s for hitting targets, a holiday gift, or just recognition for your hard work. However, the excitement can be dampened when you see the tax withholding on your bonus paycheck. It often seems like bonuses are taxed at a much higher rate than your regular salary. But is this really the case? This article breaks down how bonuses are taxed and explains why it might feel like a bigger chunk of your bonus goes to taxes.

Woman happily holding bonus check

Key Points to Understand About Bonus Taxes:

• Bonuses are considered supplemental wages by the IRS and are subject to federal and state income taxes, as well as payroll taxes.
• For bonuses under $1 million, employers often use a flat federal withholding rate of 22%.
• Bonuses exceeding $1 million are taxed at 22% for the first million and 37% for the amount over $1 million.
• Bonuses are also subject to Social Security and Medicare taxes, just like your regular wages.
• Strategic financial planning, like contributing to retirement accounts, can help manage your overall tax liability on bonuses.

How are bonuses taxed compared to regular income?

While bonuses are taxed as income, just like your regular wages, the IRS classifies them as “supplemental wages.” This distinction leads to different federal tax withholding rules. When you receive a bonus, especially if it’s issued separately from your regular paycheck, it can be subject to a flat federal withholding rate, which might appear higher than your usual income tax rate.

Generally, for bonuses of $1 million or less, employers have options for withholding. They can either include the bonus with your regular pay and apply standard payroll withholding, or they can use a flat 22% federal withholding rate. Many employers opt for the flat rate method because it’s simpler to calculate and apply.

Example: Let’s say you receive a $6,000 bonus, and your employer uses the flat 22% withholding rate. In this case, $1,320 would be automatically withheld for federal taxes and sent to the IRS ($6,000 x 0.22 = $1,320).

For very large bonuses, specifically those exceeding $1 million, the tax withholding structure is tiered. The first $1 million is withheld at 22%, and any amount beyond that is subject to a higher 37% federal withholding rate.

Example: Imagine you receive a substantial $2 million bonus. The federal tax withholding would be calculated as follows:

• $1,000,000 x 0.22 = $220,000 (tax withholding on the first million)
• $1,000,000 x 0.37 = $370,000 (tax withholding on the second million)
• Total federal tax withholding: $220,000 + $370,000 = $590,000

Are bonuses subject to state and local taxes?

Yes, bonuses are not only subject to federal income taxes but also to state and potentially local income taxes, depending on where you live and work. Just like federal taxes, state income tax rules consider bonuses as part of your taxable income. The specific state tax withholding rate will vary based on your state’s tax laws and withholding guidelines. It’s important to remember that the perceived “high” tax on bonuses includes both federal and applicable state and local income taxes.

What about other taxes like Social Security and Medicare?

In addition to income taxes, bonuses are also subject to payroll taxes, which fund Social Security and Medicare. You will generally have to pay:

• Social Security tax: This is 6.2% of your wages, including your bonus, up to a certain annual limit. For 2024, this limit is $168,600, increasing to $176,100 in 2025. Once your total wages for the year exceed this amount, you no longer pay Social Security tax for the remainder of the year.
• Medicare tax: This is 1.45% of all your wages, including your bonus, with no wage base limit.

These payroll taxes further contribute to the overall tax amount deducted from your bonus.

TurboTax Tip:

Maximize your pre-tax deductions to reduce your taxable income. Contributing to a 401(k), traditional IRA, or Health Savings Account (HSA) can lower your current year’s taxable income, potentially offsetting some of the tax impact from your bonus.

How are bonus taxes actually withheld? Percentage vs. Aggregate Method

When it comes to the mechanics of tax withholding on bonuses, employers typically use one of two methods:

1. Percentage Method (Flat Rate Withholding): This is the simpler method where your employer withholds a flat percentage from your bonus. For federal taxes, this is often the 22% rate (or 37% for the portion exceeding $1 million). This method is straightforward and is often used when bonuses are paid separately.

2. Aggregate Method: In this method, your bonus is combined with your regular wages for the payroll period, and taxes are calculated on the total amount. This means the withholding from your bonus will be based on your regular tax bracket. For instance, if your overall tax bracket is 25%, approximately 25% would be withheld from your combined pay (including the bonus).

The aggregate method doesn’t necessarily mean you pay more taxes overall. It simply means the withholding might be higher upfront, potentially leading to a larger tax refund later if your overall tax liability is less than what was withheld. However, it can reduce the immediate cash you receive from your bonus.

To get a clearer picture of potential withholding under each method, you can use online bonus tax calculators. These tools can help you estimate how much tax might be withheld from your bonus, allowing you to better understand your net bonus amount.

When are bonus taxes paid to the IRS?

Taxes withheld from your bonus are remitted to the IRS (and state/local tax authorities) by your employer according to payroll tax schedules. This means the tax payment is ongoing throughout the year, not just when you file your annual tax return.

When you file your annual tax return, you reconcile your total tax liability for the entire year, including your bonus income, against the total taxes withheld throughout the year (from your regular paychecks and bonuses). If the total withholding is less than your actual tax liability, you will owe taxes. Conversely, if you’ve overpaid through withholding, you’ll receive a tax refund.

Why does bonus tax withholding feel so high?

The perception that bonuses are taxed “so high” primarily stems from the flat percentage withholding method (often 22% federally). This flat rate can be higher than the marginal tax rate you typically pay on your regular income.

Here’s why it feels like more:

• Lump Sum Perception: Bonuses are often seen as a single, large sum of money, and seeing a significant portion withheld at once can be jarring compared to smaller, incremental withholdings from regular paychecks.
• Supplemental Wage Rules: The IRS rules for supplemental wages allow for this flat withholding rate, which is designed to simplify tax administration but can lead to higher upfront withholding.
• Avoiding Underpayment Penalties: Withholding at a flat rate helps ensure that enough tax is withheld on the bonus income, reducing the risk of taxpayers owing a large sum at tax time or facing underpayment penalties.

Ultimately, the higher withholding is not necessarily a higher tax rate in the long run. It’s just a method of prepayment. When you file your tax return, bonuses are taxed at your regular income tax rates, just like all your other income. If the withholding was too high, you will get the excess back as a refund.

Are all types of bonuses taxable?

Generally, yes. Cash bonuses and anything considered a cash equivalent (like gift cards easily convertible to cash) are fully taxable as income under Section 61 of the Internal Revenue Code. There are very few exceptions that would exclude bonuses from taxation.

However, some “fringe benefits,” like certain non-cash gifts of nominal value (e.g., a small gift basket, company swag), might be considered de minimis fringe benefits and not taxable. But, more substantial benefits or those easily converted to cash are generally taxable.

Achievement awards, which might be given instead of traditional bonuses, can also be taxable, especially if they are in the form of cash, cash equivalents, vacations, tickets, or other items that have a clear monetary value. The taxability often depends on the nature and frequency of the award.

Can you avoid or lower taxes on bonuses?

While you can’t entirely avoid taxes on bonuses (as they are considered income), you can take steps to manage and potentially lower your overall tax liability related to them.

Strategies to Lower Bonus Taxes:

1. Increase Retirement Contributions: Contributing a portion of your bonus directly to a pre-tax retirement account like a 401(k) or traditional IRA reduces your current taxable income. This is one of the most effective ways to lower your immediate tax impact and save for retirement simultaneously.

2. Defer Bonus (If Possible): If you anticipate being in a lower tax bracket in the following year (e.g., if you plan to retire or expect a significant income reduction), you could ask your employer about the possibility of deferring your bonus payment to the next tax year. This strategy only works if your employer agrees and it aligns with tax regulations on deferred compensation.

3. Health Savings Account (HSA) Contributions: Contributing to an HSA is another way to reduce taxable income while saving for healthcare expenses. HSA contributions are tax-deductible, grow tax-free, and can be used tax-free for qualified medical expenses.

4. Itemize Deductions: If you itemize deductions instead of taking the standard deduction, you might find ways to utilize your bonus to pay for deductible expenses. For example, if you have significant medical expenses exceeding 7.5% of your Adjusted Gross Income (AGI), using bonus funds to pay those could provide a tax benefit. Similarly, charitable donations made with bonus funds can be tax-deductible for those who itemize.

Will you get a refund if too much is withheld from your bonus?

Yes, absolutely. If the tax withheld from your bonus (and your regular pay throughout the year) exceeds your actual total tax liability for the year, you are entitled to a tax refund for the overpayment. The flat withholding rate of 22% is just a withholding rate, not your final tax rate. Your bonus income is ultimately taxed at your marginal income tax rate, just like your other earnings.

If you find that you consistently receive large refunds due to bonus over-withholding, you might consider adjusting your W-4 form with your employer. You can increase your allowances or request additional withholding to better align your withholdings with your expected tax liability. However, for many, receiving a refund is a welcome outcome, essentially acting as a forced savings plan.

For personalized tax advice and to ensure you are optimizing your tax situation, consider using tax preparation software like TurboTax. TurboTax offers various options, from DIY software to expert-assisted and full-service tax preparation, to help you navigate bonus taxes and maximize your tax outcome. You can log in to TurboTax to get started or explore their refund calculator for tax planning.