While receiving a bonus is a nice financial windfall, it can also create confusion about how exactly it will be taxed. The IRS has different guidelines for the taxation of supplemental wages compared to regular salary. Understanding these rules will help you know what to expect when you receive your bonus.
How bonuses impact tax withholding.
For most of us, when we receive a paycheck, our employer automatically withholds a portion for taxes. Your employer will use the allowances you claimed on your W-4 and the IRS’ tax tables to calculate what percentage of your salary is withheld from each paycheck.
Certain forms of compensation such as bonuses, severance pay, awards, and commissions are considered supplemental wages and can impact this calculation. The IRS gives employers the choice between two methods of supplemental wage withholding.
The percentage method.
The percentage method is the most common withholding option for employers because it is the most simple. Under this method, your employer will distinguish your bonus as separate from your regular income and withhold a straight 25% of the bonus for federal income taxes.
The aggregate method.
Under the aggregate method, your employer adds your bonus to your regular salary and calculates your federal tax withholding based on your W-4 and the IRS’ withholding tables. The result could push you into a higher marginal tax rate for withholding for that pay period.
Here’s an example: if you’re single, paid bi-weekly and earn an annual salary of $85,000/year, you’re likely in the 25% marginal federal tax bracket. Now assume you receive an $8,000 bonus in your next paycheck. Under the aggregate method, your bonus and income will be combined and probably push you into the 33% marginal income tax bracket for this pay period. Of course each individual’s tax situation will vary, but this example illustrates how the different methods can impact after tax pay.
If you’re trying to forecast how much of your bonus will end up in your pocket, make sure you consider the big picture. Like your salary, your bonus will still be subject to state income tax, Social Security, and Medicare taxes.
If you elect regular contributions to a company 401(k), your employer may automatically apply the same percentage to supplemental income. If you’re concerned about reaching the limit ($18,000 in 2015 for those under 50 years old) speak with your employer in advance.
A note on deductions.
When considering your total annual tax liability, tax deductions play a large role in the calculation. People often make universal reference to tax deductions, without differentiating between them. This can be misleading, as there are different standards for different types of deductions, and meeting them determines your eligibility.
• Above-the-line deductions: examples such as student loan interest payments and alimony payments directly reduce your adjusted gross income (AGI). Each deduction may have its own qualifying criteria to determine your eligibility, such as income.
• Standard deduction versus itemized deductions: whether you claim the standard deduction or choose to itemize deductions will depend on whichever is greater for you. For example, if your state and local taxes and mortgage interest are greater than the standard deduction available to you, it often makes sense to itemize your deductions
• Below-the-line deductions: this is where most of the confusion lies. There are numerous deductions in this category, some of which are subject to the 2% limit of your AGI and others which are not. To determine if you’re eligible to use deductions subject to the 2% limit, the total of these expenses must exceed 2% of your adjusted gross income. Assuming it does, only the amount in excess of the 2% AGI floor is eligible for a deduction. The complete IRS guidelines can be found here.
Many factors will ultimately determine your annual tax liability, so it is important to work with a financial advisor during the year to develop a strategy for your income taxes, and also a qualified tax preparer to ensure you’re making the most of the deductions available to you and your returns filed properly.
Financial Planning Association of Massachusetts member Kristin McFarland is the Director of Strategic Partnerships with The Darrow Company in Boston. The Darrow Company is a fee-only asset management and financial advisory firm focused on building and preserving the wealth for their diverse client base.
Kristin McFarland is an investment adviser representative of The Darrow Company, Inc., an SEC registered investment adviser located in Massachusetts. The material contained in this article is for general information only and should not be construed as the rendering of personalized investment, legal, accounting, or tax advice.