Bonuses are a popular way to increase employee loyalty and reward a year’s worth of “jobs well done”. However… as far as payroll goes, they are often misunderstood. With those holiday bonuses on the way, let’s cover one of the most common end-of-year payroll questions: how are bonuses taxed? It’s an oft-repeated question, especially at the end of the tax year, and the answer is… it depends. Let’s dive into it!
How are Bonuses Taxed?
Bonuses are Treated as Income
First, let’s clear this up right away: in payroll and tax terms, bonuses are treated the same as other sources of income, and are therefore subject to all relevant federal and state taxes — including FICA. Businesses are required to log any and all bonuses to their employees’ W-2s.
Bonuses Have Different Withholding Methods
What sets bonuses apart, and is a constant source of confusion, is that the withholding options for bonuses are different from the standard paycheck.
There are two withholding methods: Separate and Aggregate.
Separate Withholding
This is the easiest method for the employer, and it treats a bonus as separate from the employees regular paycheck. Employers choosing this method can ask their employees if they have a specific amount or percentage that they would like withheld. If not, then it will withhold at the rate based on their W-4 and State equivalent (if applicable) elections. Always good advice to have your employees update their W-4 and State equivalent periodically to ensure proper withholding is being applied.
Aggregate Withholding
In this method, the employer combines the bonus with a regular paycheck. This means that the tax rate is applied as usual based on the employee’s W-4 and State equivalent (if applicable). Keep in mind that most payroll systems “annualize” taxable wages based on the tax tables and the employee’s W-4 elections. Which means their tax deductions could be skewed due to a higher one-time bonus. This could bump up an employee into a different bracket for this one time and thereby withhold more than they may want.
Other Rules and Regulations
However, there are a few more variables that further complicate the “How are bonuses taxed” equation. There are special rules in cases of:
- Huge bonuses. Seven-figure bonuses trigger a higher withholding.
- Incentive plans. In certain industries as listed on the 1099-misc, no taxes are withheld on their bonuses. However, employees still have to report the bonus as income.
- Delayed bonuses. A company can agree to delay the bonus until the next fiscal year at an employee’s request. However, it’s important to note that this doesn’t eliminate the tax hit, only postpones it. Before agreeing to this, be sure to advise your employee to consult a tax professional.
- Retirement plan contributions. Employees can opt to put some or all of their bonus into a 401(k) plan in certain cases. This will affect how they are taxed.
- “Bonuses”. Not all bonuses are paid in cash, and therefore certain rules won’t apply. There’s a lot of gray area here, so we recommend prudence if this is how you choose to give out your bonuses.
Our Advice? Let Us Worry About It!
The question “how are bonuses taxed” comes up as often as it does for good reason: the answer is confusing! If you’re not sure how to distribute your bonuses or how they will be taxed, it’s time to call in the pros. Working with a payroll firm like Capital Payroll Partners guarantees that your bonus has the intended effect on your employees. If you’re ready to move forward, get a quote on our pricing today. If you have any questions, fill out the form below and let us know how we can help!