Why the Bonus Tax Rate Is Bad News for Your Tax Refund
You might be surprised to learn that your bonus can be taxed at a higher rate than your regular earnings. In fact, the IRS imposes a tax rate of 22% on the first $1 million in bonus income and a tax rate of 37% on anything above that.
Even the 22% tax bill can make a bonus feel less exciting. But knowing the rules regarding bonus taxation can help you prepare for the hit. The information below can help you understand and minimize the taxes associated with bonuses.
How Are Bonuses Taxed?
The IRS subjects your bonus to Social Security, Medicare and income taxes just like it does your regular income. But because the IRS defines bonus income as supplemental, different rules apply to how much tax is withheld from your check. To ensure that you pay these taxes, employers withhold taxes using one of the following two methods:
As the name implies, this method involves holding back a specific percentage of the bonus. Your employer may choose this option if it pays your bonus separately from your regular earnings or otherwise distinguishes your bonus from your regular earnings. Assuming the bonus amounts $1 million or less, the employer will withhold 22%, the bonus tax rate for tax year 2020 in most cases. Hence, if you receive a $10,000 bonus, the employer will withhold $2,200 for income tax. The percentage increases to 37% on bonus earnings above $1 million.
Employers use the aggregate method when they include bonus pay with an employee’s regular earnings. Under this method, the IRS still defines bonuses as supplemental income, but the employer treats the bonus portion as regular pay for tax withholding and uses the information on your W-4 form to determine what percentage of the total earnings to withhold.
The aggregate method can result in the employer withholding more tax than the employee owes, leading to a lower bonus payment. In this case, you would have to wait until you file your tax return to have your overpayment refunded.
Exceptions to the Usual Bonus Rules
As mentioned before, tax withholding depends on your individual tax situation. Special circumstances can subject you to a higher tax rate or place you in a different tax category.
Bonuses Over $1 Million
The IRS taxes your first $1 million in bonuses at the standard 22% tax rate. But different rules apply for bonuses above $1 million. All bonus money received over the $1 million threshold has a tax rate of 37%, so an employer using the percentage method will withhold 37% of that portion of the bonus for tax purposes. So, for example, if you received a bonus of $1,100,000, $1 million would be subject to 22% withholding and $100,000 would be subject to 37% withholding.
Incentive payments work differently than bonuses or regular wages. The IRS considers these earnings to be non-employee compensation. An example is a car salesman who earns bonus income from the auto manufacturer instead of the dealership that employs him.
Your employer doesn’t withhold tax from non-employee compensation, nor does it report the income on your W-2. Instead, the company that issued your payment will report your earnings on a 1099-MISC or 1099-NEC. You report the payments on Schedule 1 if you’re an employee, or Schedule C if you’re self-employed. You might have to file Form 1040-ES to report and pay the estimated tax on those earnings.
What the Bonus Tax Rate Means for Your Tax Refund
A bonus could make the difference in whether you qualify for certain tax credits or deductions. And because the IRS taxes bonuses differently than regular income, those extra earnings could affect any tax refund you might be entitled to. What effect it has could depend on the withholding method your employer chooses.
Should your employer use the percentage method, you would see a 22% tax, plus any Social Security, Medicare, state, local or other taxes withheld. In the case of taxpayers who earn less than $40,125 in 2020 ($80,250 for married couples filing jointly), the 22% income tax exceeds your 12% tax bracket. Such a situation could lead to a higher refund.
The aggregate method would probably withhold an amount that more closely corresponds to your tax bracket. But this still could increase the size of your refund if you’re currently having too much withheld, as the excess withholding would also apply to the bonus income.
Keep Reading: Here’s the Average IRS Tax Refund Amount
How Can You Avoid Paying Taxes On Your Bonus?
You will likely want to minimize the effect of the bonus on your tax return. Fortunately, the tax code offers some loopholes for this purpose. You can take advantage of commonly-missed tax deductions, for example, or donate some or all of your bonus to help to minimize the tax burden.
That said, tax-deferred accounts might offer the most straightforward solution for avoiding taxes on bonus earnings. These accounts come in many forms, such as a health saving account you fund from pre-tax earnings to pay medical expenses. But most tax savings revolve around retirement accounts.
Here’s how the following accounts can help you reduce the tax burden resulting from your bonus:
401(k) plans offer a way for employees to contribute a before-tax portion of their paychecks to a retirement account. In this case, you will pay taxes once you withdraw the money, which happens after reaching age 59 1/2 in most cases. For 2020, the annual maximum for 401(k) contributions comes to $19,500, plus a $6,500 catch-up contribution if you’re age 50 or older. Since few people contribute this amount, most have the option of increasing 401(k) contributions.
Your employer might not allow you to put your entire bonus into your 401(k) even if you haven’t maxed out your contribution, but the extra income can give you room within your budget to increase the percentage of income you’re currently deferring to your account. Jim Brown, founder of Your Best Mindset, describes putting your bonus into your 401(k) as a relatively painless way to optimize contributions. Brown points out that the more you place in your 401(k), the more you reduce your tax bill.
A traditional IRA might provide a more straightforward way to defer the taxes on your bonus. For 2020 and 2021, the maximum contribution is $6,000 — $7,000 if you’re 50 or older. Like the 401(k), a traditional IRA allows you to contribute before-tax dollars to a retirement account. Growth is tax-free, and you will pay taxes when you withdraw money from the account. You can make withdrawals beginning at age 59 1/2. Assuming your bonus amounts to $6,000 or less ($7,000 or less for those 50 and over), you may distribute the entire bonus to avoid taxes on the payout.
A Roth IRA works much the same way as a traditional IRA, except with a Roth you contribute after-tax dollars. Hence, you will still have to pay taxes on the bonus, but you will receive tax-free growth and withdraw the funds tax-free once you reach age 59 1/2 in most cases. You must have earned less than $139,000 ($206,000 if married and filing jointly) in 2020 to contribute to a Roth account. That amount increases to $140,000 and ($208,000 if married and filing jointly) for tax year 2021. To contribute the full amount, you must have earned less than $124,000 ($196,000 if married and filing jointly) in 2020. That threshold increases to $125,000 ($198,000 if married and filing jointly) for 2021.
Making the Bonus Tax Rate Work for You
In the event you’re due a bonus, you should make yourself aware of the effects of that money on your tax return while maintaining a degree of perspective. You will come out ahead regardless of whether your employer uses the percentage method or the aggregate method to determine tax withholding.
The payout can provide an opportunity to fund accounts previously ignored. Perhaps you could fully fund a health savings account, a 401(k) or an IRA if you have not already contributed the maximum. Such accounts can help you escape some or all of the income taxes associated with the bonus.
The financial windfall a bonus provides can have unexpected repercussions. By knowing how to handle the possible tax consequences, receiving the extra money will be less taxing in the end, both emotionally and financially.
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Daria Uhlig contributed to the reporting for this article.
Last updated: Feb. 23, 2021