How Bonuses Are Taxed

Many employers typically pay year-end bonuses in the first quarter of the year. If you received a bonus for the first time this year, you may be surprised at the net amount of your "windfall."

WHY THE SURPRISE?

Work bonuses are classified as supplemental wages, which are subject to federal income tax withholding. They are also subject to Social Security and Medicare taxes, and in some cases, state taxes may apply. The IRS provides employers with specific guidelines outlining the methods for calculating federal income tax on supplemental wages.

The default rate for federal income tax withholding on bonuses less than $1 million is currently 22%, so employers can withhold at a flat rate of 22% or combine regular and supplemental wages to calculate the tax amount. That means your bonus may be taxed at your highest individual income tax rate, which could be 37%, not to mention any state tax. You may receive some of the withheld amount back as a tax refund. Check with your tax professional.

HANDLING THE INFLUX OF CASH

So, now that you're over the tax sticker shock, what will you do with your windfall? First, reward yourself in some small way, such as a weekend away or an item you have wanted. Then, a good move is to contribute the rest to tax-advantaged accounts such as a 401(k), IRA or Health Savings Account (HSA). By contributing part of your bonus to these accounts, you save for your future and may offset some of your tax bill for the year.

Another way to minimize work bonuses' tax impact is to consider charitable contributions. Donating a portion of your bonus to qualified charitable organizations not only supports meaningful causes but also provides a deduction that could lower your taxable income.

While it won't reduce taxes, you may want to use some of your bonus to pay off a high-interest credit card or student loan. Be careful not to become reliant on annual bonuses. In tight economic times, bonuses can be reduced or even suspended.

The choice is yours, but being proactive and strategic with your bonus can lead to substantial tax savings and long-term financial benefits.