Your income taxes are charged based on combined state and federal tax rates, plus FICA taxes. By default, bonuses aren’t taxed at a flat 40% rate. However depending on your income level, your bonus might push you in to a higher marginal bracket, which can then lead to a very high withholding rate on your on bonus. The good news it that when you file your income taxes at year end, you will be eligible for tax refunds if you were taxed too much.
Keep reading, and I’ll dig a little deeper into how the IRS treats taxes and what you need to be wary of when receiving a bonus for a job well done! I do appreciate that things can get quite confusing, so I’ve done my best to help simplify this as much as possible.
Multiple Levels of Income Taxes
It’s important to understand that you will typically have to pay income-based taxes in the US based on three different levels:
- Federal Income Taxes: This is what you pay to Uncle Sam in DC. The federal income taxes support the services provided by the federal government. Tax rates are progressive, meaning you pay more as you earn more. The marginal tax brackets decide how much in taxes you pay for each extra dollar of income that you earn.
- State Income Taxes: This is what you pay to your state government. State income taxes vary and can be as low as 0% in states like Texas and Florida. In California or New Jersey, the marginal tax rates can climb as high as 12-13% if you are in the highest income bracket. You can see more about state tax rate here.
- FICA taxes: While these are not strictly income taxes, they are calculated using your income as a base. FICA taxes fund Social Security and Medicare and you are charged 7.65%, up to a pre-defined maximum level of income.
Of course there are numerous nuances and adjustments to these basic rates based on your filing status, 401k contributions, property ownership, etc.
If your bonus is paid in the form of cash or a cash-equivalent basis (equity, a gift certificate, tips, etc.), your bonus will most likely be taxed along with the rest of your income. Let’s explore that further.
How does the IRS tax my bonus?
The IRS allows your employer to calculate the tax rate on your bonus either as a percentage, or as part of the ‘aggregate’ method. Here’s what you need to know.
You’ll receive a percentage tax charge if your bonus pays separately to your paycheck. This is how it’s calculated:
- Federal withholding: A flat tax rate of 22% if your bonus (and other supplemental income) is less than $1 million. If you are over $1 million, this could be as high as 37%.
- State withholding tax: If your state charges taxes, that will be added on here.
- FICA tax: If your bonus does not tip you over the maximum limit for the year ($147,000 for 2022; $160,200 for 2023), you will potentially have another 7.65% withheld here.
Your employer can choose to withhold the combined sum of the above three rates from your bonus. Depending on your level of bonus and the state that you live in, you can see how the withholding tax rate can quickly approach 40%.
The ‘aggregate’ method treats your bonuses and other supplemental income as part of your normal pay. This simple change in method means that all of a sudden, the marginal tax rate will be used for calculating the withholding rate. If you are a high income earner, then you can easily be charged a very high rate.
Your employer will typically have to use the aggregate system if, for example, they don’t differentiate between bonuses and typical wages on your paychecks. When your employer rolls your bonuses and any other supplements into your regular paycheck, it can seem as though you’re being taxed more than through percentage. That’s because your wage effectively increases, which may push you into higher federal tax brackets.
Again, using the same steps as discussed above, your bonus check will have taxes withheld for 3 different levels of taxation:
- Federal taxes: Withholding marginal tax rate will exceed the 22% discussed above if you are earning over $95.4k in total income as an individual, or $190.8k in family income (if married and filling jointly or qualifying widower).
- State taxes: Same as discussed above. Any state taxes will get added here.
- FICA tax: If you are below the threshold, 7.65% will get added on here.
There are many different combinations of income and filing statuses that can easily push your bonus withholding rate to 40% or higher.
Let’s consider two simple examples:
- Single person living in California with an annual salary of $140,000 in 2023. If you receive a bonus of $7,000 at the end of the year, your combined marginal income tax withholding rate based on three levels of taxation could be 40.95% (24% federal + 9.3% state + 7.65% FICA).
- Married couple living in New York with combined family income of $350,000 and receives a bonus of $30,000. The total marginal income tax withholding rate could be 41.2% (32% federal + 6.85% state + 2.35% for Medicare). As they’re above the Social Security cap, the FICA withholding rate is lower than the typical 7.65%.
There are many other combinations that would cross the 40% threshold, but hopefully this helps you get an idea. Refer to our article discussing how combined marginal tax rates can really be punishing.
Percentage Method vs Aggregate Method
So which method would lead to a higher withholding rate on your bonus? The deciding factors are:
- Is your federal marginal bracket charged greater than 22% (assuming your bonus is less than $1 million)?
- Are you over the annual contribution threshold for FICA?
Unfortunately not a straight answer as you can see. Is anything ever straight forward with taxes?!
You will have to check the federal income tax brackets to determine where you fall. Again the good news is that when you file your income taxes at the end of the year, both methods will lead to the same final answer. So if you end up getting overcharged under either of the methods, you will get a tax refund. However if you were undercharged, you also have to be ready to pay up the additional amount owed.
Do I have to pay tax on my bonuses?
Under mostly all circumstances, yes, you’ll have to pay tax on bonuses you receive. That applies even if you receive payment in the form of a gift certificate or paid leave!
However, if you receive what your employer deems to be a special ‘award’ without a cash equivalent, you may not have to pay tax. For example, this may be personal property, or a physical trophy or award!
Is a bonus a ‘supplemental wage’?
Yes – the IRS defines any bonuses you receive as ‘supplemental’ income. That means it’s an extra payment that goes beyond your usual wage expectations.
Supplemental wages are taxed in one of two ways, and I’ll explore those in a little more detail below.
Other types of supplemental wage
As well as performance bonuses, the following all apply as supplemental wages, according to the IRS:
- Employment awards
- Sick leave payments
- Back pay
- Pay increases (retroactive)
- Compensation (such as equity)
This list isn’t exhaustive. Be sure to read your paycheck carefully and to speak with your employer or payroll administrator if you’re concerned.
How to avoid taxes on your bonus check
You can’t easily reduce the tax withheld on your bonus check as your employer will be using some default assumptions and calculations when calculating the tax withholding rate.
However what you can do is to ensure that you maximize the deductions that you are claiming on your income tax filings to help reduce the total tax bill. If you do this properly, you can be on your way to a nice fat income tax refund check! Let’s take a look at some easy approaches. Of course we are only focusing on legal methods here!
- 401k contribution: The best and easiest way to reduce taxes on your bonus is to contribute that additional income into a 401k account. If you don’t already do this, then you can claim up to $20,500 for your 2022 income. As this deduction helps reduce your income at the marginal income tax rate, it has the highest bang for your buck (quite literally) in terms of options. You could open a brokerage account with someone like M1 Finance or eToro so you can invest in ETFs or stocks.
- Mortgage interest deduction: If you own a home, the interest you pay on your mortgage qualifies for a deduction.
- Children and Dependant care: There are multiple categories of tax credits and refunds here which you could qualify for. Be sure to properly check the boxes on your tax prep software to ensure that you are claiming these deductions.
- Invest in yourself: The American Opportunity tax credit and the Lifetime Learning credit let you claim deductions for tuition, books, fees, etc.
- Charitable donations: If you are donating to registered charities, be sure to ask them for a tax receipt. You can claim this amount as a deduction.
There are many other methods out there. Tax prep software can help you catch many of these methods. That filing work may seem boring, but if you miss a few small details, it could cost you thousands of dollars!
If your tax bill is quite high, it might be worth it to get professional tax help with tax planning as there are many elaborate – and legal – ways of reducing your tax bill further! Ultimately it comes down to your specific situation and whether the cost and hassle of going through the additional hoops is worth it.
Can I avoid paying tax on my bonuses?
You may be able to legally defer payments such as bonuses into 401 accounts, IRAs, and HSAs to reduce your taxable income. However, limitations may apply.
Can my bonus put me in a higher tax bracket?
Yes – depending on how much you receive in supplemental income, if it’s treated as an aggregate payment, you could end up paying a higher federal tax rate.
Will I get a tax refund on my bonus?
You will only get a tax refund if you have over paid taxes over the year on your total income – which includes your base salary and bonus. This could happen if your employer withheld your taxes at too high of a rate; or if you were able to intelligently use the various tax deductions to help reduce your taxable income.
by Brianna Johnson
Brianna Johnson, a Miami-based finance veteran, is a wealth advisor for high net-worth families. She loves to write and to share her knowledge. For PFF, she writes in-depth articles on finance and investments that help readers get unique insights. See more.