How Are Bonuses Taxed?
There are two primary methods for calculating federal income taxes on bonus payments for your employees: Percentage Method and Aggregate Method.
Are you a small business owner that’s rewarding your employees with a bonus? You will need to decide how much to give, when to distribute the bonus, and calculate how much taxes to withhold (spoiler alert: tax calculations for bonuses are different from regular wages).
Or maybe you’re an employee receiving a bonus for your hard work, and you want to know the tax implications of receiving this supplemental income.
No matter which situation you’re facing, we’re here to help. In this guide, we’re going to break down everything you need to know about bonuses and taxes. We’ll walk you step-by-step through how to tax bonuses, calculate withholdings, how to offset your tax liability as an employee, and how to handle taxes on bonuses if you’re self-employed.
Keep reading to learn more!
Table of Contents
How Are Bonuses Taxed For Employers?
There are two primary methods for calculating federal income taxes on bonus payments for your employees.
The Percentage Method For Calculating Bonus Taxes
The percentage method is the easiest way to calculate bonus taxes. Using this method, you withhold a flat income tax rate of 22% from the bonus amount. No other percentages can be used. This tax rate applies only to bonuses or other supplemental income. If regular wages are also paid at the same time, the flat rate of 22% only applies to the bonus.
Let’s look at an example. Your employee, John, will receive a $2,000 bonus, and you decide to use the percentage method.
- Multiply the bonus amount ($2,000) by 22% (.22). The total is $440. This is the amount of taxes you will withhold from the bonus.
- Subtract the amount withheld ($440) from the gross bonus amount ($2,000). This leaves you with $1,560. This is the amount that John nets after taxes are withheld.
One last thing to note is that the 22% tax rate applies to supplemental pay (including bonuses) up to $1 million. Bonuses or supplemental income exceeding $1 million is taxed at a 37% rate. For most small businesses, though, this won’t be a concern.
The Aggregate Method For Calculating Bonus Taxes
The aggregate method for calculating bonus taxes is a little more complex. Using this method, you will use both the amount of the bonus and the employee’s regular wages to perform your calculations. Let’s break down how this works.
- Add the employee’s bonus to regular wages that are paid at the same time.
- Use this total to find the amount to withhold using the tax brackets in IRS Publication 15. (Write down this number — you’re going to need it later.)
- Next, use the tax brackets to determine how much to withhold ONLY on the employee’s regular wages.
- Subtract the taxes from regular wages in step 3 from the aggregated total of bonus and regular wages from step 2. This is the amount that you will withhold from the bonus payment.
While it sounds confusing, let’s clear up any questions with an example.
Your employee, John, makes regular wages of $1,000. According to his W-4, he is single, has just one job, and doesn’t have any dependents. John will receive a year-end bonus of $2,000. To calculate the amount of federal taxes to withhold, take the following steps:
- Add John’s bonus amount ($2,000) to his regular wages ($1,000). The sum is $3,000.
- Use IRS Publication 15 to find the amount of taxes to withhold from $3,000. Based on the data from John’s W-4, this amount is $393.
- Use IRS Publication 15 to find the amount of taxes to withhold from John’s regular wages ($1,000). Based on the data from John’s W-4, this amount is $54.
- Subtract the total from step 3 ($54) from the total in step 2 ($393). The total is $339. You will withhold this amount from John’s bonus check of $2,000.
In addition to federal income taxes, you will also need to withhold Social Security, Medicare, and state taxes from your employee’s bonus.
Which Bonus Tax Method Should You Use?
Now, it’s time to decide which bonus tax method you’ll use. While it may seem logical to use the percentage method because it’s easier, there are a few exceptions to note.
According to the IRS, you can choose from either method if you withheld income tax from the employee’s regular wages during the current or immediately preceding calendar year. If income tax was not withheld from the employee’s regular wages during that time period, you will have to use the aggregated method for calculating taxes withheld on bonuses.
While the percentage method is easier, it may result in the employee receiving less money upfront than if you had used the aggregated method. On the other hand, this also helps the employee avoid underpaying on taxes and having to make a bigger payment come tax time. Any tax overages paid in by the employee will be available as a tax refund after they file their income tax returns.
How Are Bonuses Taxed For Employees?
Fortunately for employees, the hardest work when it comes to taxation on bonuses is left up to the employer. However, it is important to keep in mind that bonuses are taxed at a higher rate than regular wages. Under IRS rules, bonuses are considered supplemental income, which is defined as wages that are paid to an employee that aren’t regular wages. Supplemental income includes bonuses, tips, commissions, overtime pay, accumulated sick pay, severance pay, awards, and prizes. Your employer will calculate the taxes on your bonus using one of the two methods described earlier in this post.
The 2021 Year-End Bonus Tax Rate
The federal withholding rate for supplemental wages in 2021 is 22%. Supplemental wages include bonuses, commissions, tips, overtime pay, accumulated sick leave, awards, and prizes.
Can You Avoid Bonus Taxes?
Unfortunately, there’s no way to avoid bonus taxes. IRS rules require you to pay taxes on any type of supplemental wages, including bonuses.
However, if you are worried about how your bonus will affect your tax return, there are a number of ways that you can lower your tax liability. To lower your tax liability, you must reduce your amount of taxable income. Some ways that you can do this include:
- Contribute or increase contributions to an employer-sponsored 401(k) or 403(b) plan
- Contribute or increase contributions to individually-held IRAs
- Itemize charitable contributions
You can also find savings by working with a tax professional or by using tax software, which makes it easy to find deductions and tax credits that can help lower your tax liability.
How Do You Report A Bonus On Your Tax Return?
Reporting a bonus on your tax return is simple. The W-2 you receive from your employer at the beginning of the year will include your bonus as part of your wages. This amount will then be reported on line 1 of your Form 1040 when filing your tax return.
What If You Are Self-Employed?
If you’re self-employed and received a bonus, things work a little bit differently. Since you aren’t an employee, you won’t receive a W-9. Instead, your bonus (along with any other income) will be reported on your 1099-MISC in Box 7. Your income (which includes any bonus you received) will be subject to self-employment and income taxes.