How are bonuses taxed?
Just like a portion of your paycheck goes toward prepaying your taxes, the same process occurs with bonuses. However, since they’re are not ordinarily part of your income, bonuses are designated as supplemental income, instead of just being added to your paycheck and taxed the same way. According to the IRS, any supplemental wages should have federal income tax withheld at a 22% flat rate.
What is supplemental income?
The IRS has a category called "supplemental wages" that includes severance pay, back wages, vacation payments, moving costs, overtime, taxable benefits, commissions and bonuses.
The reason for categorizing income is so it can be treated differently for income tax-withholding purposes. The IRS and your employer treat bonuses in two different ways:
1. The percentage method
The IRS says all supplemental wages should have federal income tax withheld at a rate of 22%. So for a $10,000 bonus, you'd have $2,200 withheld in federal income taxes and receive $7,800.
This is the simplest method, so chances are your employer most likely will withhold the percentage from your bonus. Fortunately, it's also the most beneficial to you.
2. The aggregate method
When your bonus is included in your regular paycheck, things get complicated. First, your employer calculates the normal withholding amount for your entire paycheck. Then it subtracts what was withheld from your last paycheck from your current withholding. The rest is withheld from your bonus.
This results in a higher rate of withholding on your bonus; indeed, you might receive less money simply because of the method used to calculate withholding.
Bonuses over $1 million are taxed differently
Your bonus amount below $1 million must have 22% withheld; anything above $1 million, however, is subject to withholding at 37%.
Whichever method your employer uses, your final income tax will be based on your total taxable income for the year when you file your federal return. You'll receive credit for all the income tax withheld from your pay, including your bonus.
How to keep more of your bonus
Your best strategy is to ask for the bonus in a separate check from your salary. Then ask your employer to use the IRS "supplemental wages rate" of 22%. The employer will be in compliance with tax law, and you'll get more money.
You could also request that the bonus be given to you after the end of the year. This can be advantageous if you think you'll make less money next year, and your tax rate could be lower. If your employers uses the aggregate method on your bonus, you'll still have less tax withheld if you're in a lower tax bracket.