Are you bringing in a bonus this year? Fantastic! You should be proud of your hard work. I teach my three kids the same fundamental principle every week. Hard work pays off. It’s completely ingrained in them now. From anywhere in the house if I yell out “Hard work!” I get a sometimes emphatic, sometimes pithy response from at least one of them: “Pays off!”
This mentality is an important part of my children’s upbringing. I want them to know they’re in control of their own destiny. Speaking of being in control, let’s talk about governmental oversight and compliance regarding your bonus.
Taxing My Bonus, What Gives?
Okay, I’m going to go full-on fundamental for a moment or two, so please forgive me. Let me make a few crucially important points that we need to be on the same page about, or the rest of this won’t make any sense.
- Bonuses are not ultimately “taxed” at a special rate.
- You should never turn down a bonus because you’re afraid of being in a higher tax bracket.
- Federal income tax withholding is a process in which you make your tax payments throughout the year, rather than all at once come tax time.
Income tax specifics can be incredibly complex. For our purposes I’m going to break it down in a general way, which may not reflect your specific circumstances. If you need specific advice to a specific situation, please consult with a tax expert.
Bonuses are not ultimately “taxed” at a special rate
You don’t pay higher income tax on a bonus than you do your other wage earnings. However, the government does require that a minimum federal income tax withholding rate be applied to bonus earnings. The two can be confused very easily, so I’ll try to clarify.
Bonus: $4,000
Federal income tax withholding minimum rate: 22%
Actual federal income tax withheld: $880
Possible tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, 37%
So far, it does appear that your bonus has been taxed at a specific rate. However, this is not the case. Your withholding rate is a specific, governmentally regulated rate, but upon filing your individual income tax return you’ll determine what tax bracket you’re actually in. This is where the actual tax happens.
This fundamental piece of information is lost on most people. Just because the government requires your employer to take out a certain amount of tax from your bonus, doesn’t mean you pay that tax to the IRS, and it’s gone forever. You see, if you file your personal return, after having withheld tax at a 22% rate, and you’re in a 32% tax bracket, you’ve actually paid too little ahead of time and may owe more. If you’re in a 12% tax bracket, you’ve overpaid and are likely due a refund, depending on other factors.
You should never turn down a bonus because you’re afraid of being in a higher tax bracket
This one drives me up the wall. Tax brackets don’t work the way most people think they work. Want the secret sauce? Check out my 4 minute video describing exactly how tax brackets work:
https://www.youtube.com/watch?v=teGrGCWpEMQ&ab_channel=MolenTax
The video really ought the make this clear, but in case you’re still not 100% on it, earning more income is always better, even if you pay a slightly higher tax on the amount you earned into that higher tax bracket. You’ll never pay more in tax than what you earned. Take the bonus!
Federal income tax withholding is a process in which you make your tax payments throughout the year, rather than all at once come tax time
The federal government is run on our tax dollars. The IRS generates more than 90% of our government’s revenue each year. In order to operate, the system requires that we make payments of tax on wage income as we receive it. Not all income is wage income. Many investments and income relating to businesses have no tax withholding requirements.
Imagine for a moment that every single working person were to go to their payroll department and request a special exemption electing to not withhold any taxes on their paycheck. While this is not typical, you generally have the right to elect this for up to one year. If you owe taxes because of this, you generally cannot make this election again. However, just shoot the breeze with me for a minute here. Imagine every working person did this. All of our tax dollars would cease going to the federal government and in short order the government would temporarily shut down.
I explain this not to start a movement or to spite the government, rather to illustrate a point. The government needs your tax dollars to fulfill its obligations. The amount you withhold in taxes is done not because you’re being “taxed” as you earn income. Instead, it’s a preparatory withholding of tax you will owe on Tax Day, usually April 15th of the following year.
So, How is My Bonus Taxed?
To the point then. Your bonus is taxed at your tax rate, nothing more, nothing less. They may withhold a higher, or lower amount, but ultimately your bonus is just regular income. This principle actually jives a lot with overtime as well, since the information is quite similar.
I get that may seem like a trivial or sarcastic answer, but you wouldn’t believe how much confusion there is on this basic point. Hopefully, with all the fundamental information I’ve laid out, this makes a bit more sense.
Essentially, to better understand exactly how your bonus is taxed, you need to understand how you’re taxed in general. To get a better understanding of that, check out my long-form breakdown of how tax brackets work HERE.
Don’t Do This One Thing, or You’ll Regret It!
It turns out you can actually be too clever. Regarding bonuses, I see this most when someone who kind of understands it, but not fully, decides to game the system and claim exempt on their withholding status for the check they receive their bonus. This way they receive their entire bonus! What’s not to love?
Tax time won’t be showing you love if you do this. These regulations are generally in place for a good reason and if you under withhold on a bonus, you could easily end up owing on your next tax filing.
Finally, I would recommend you always consult with a tax expert regarding your specific circumstances. I will often counsel people I work with to go against the grain on some of these things based on their very specific situations. There is no one-size-fits-all approach to tax planning.
Wait, tax planning? The folks who are clever, but not too clever, are doing this. When was your last tax planning session? Schedule one now by contacting us today! Reference this post and I’ll give you a free 15-minute phone consultation on the spot!
Kevin Molen, EA
Advisory Services Manager
