December 23, 2016

Colorado Tax LawyersThe holiday season is here, which means that many fortunate employees around the country are about to enjoy a holiday or end-of-year bonus from their employers. Bonuses, after all, are an effective way to reward top performers and motivate employees.

But just how much of this bonus will you actually take home? Bonuses can change one’s tax return considerably, and the amount of taxes withheld depend on the payout. It may be best to read up on this matter, or you may be disappointed to find your account with an amount much lower than what you hoped for.

The Internal Revenue Service does not consider bonuses as regular wages, but as supplemental wages. This means that a bonus is separate from your hourly rate or regular salary, but is still classified as income. Other common examples of supplemental wages are moving expenses, overtime, vacation pay, commissions, back pay, and dismissal or severance pay.

Are bonuses taxed by the IRS? The answer is yes. They are generally taxed in one of two ways: The percentage method and the aggregate method.

With the percentage method, bonuses are typically taxed at a flat rate of 25%. This means that if you receive a bonus amounting to $5,000, tax rules dictate that 25% or $1,250 goes directly to the IRS. If an employee’s bonus exceeds the amount of $1 million, however, then it is taxed at a standard rate of 39.6%. Employers often choose the percentage method because it is a method that is simpler and easier to understand, and prevents higher-income earners from having a larger amount taken out of their paycheck.

The aggregate method, on the other hand, is used when an employer pays the bonus together with the most recent paycheck. The total withholding amount is computed using information found on the employee’s W-4 form. The problem with the aggregate method is that taxes are withheld at what is almost always a higher rate on the combined sum of both the regular wages and the bonus, as opposed to being withheld at a flat rate of 25% and only applying that rate to the bonus amount. This is because employees are temporarily bumped into a higher bracket of the withholding tables. Apart from resulting in a higher tax obligation for the same amount of income, the aggregate method is also believed to be more laborious and time-consuming for employers.

Some people mistakenly believe that employees are given the choice as to which tax method to use. The reality is that the final decision is up to the employer. The employer, of course, can take their employees’ preferences into consideration.

Categories: IRS