Did you receive a bonus this year? If so, congratulations! While any additional income is a good thing, there is a lot of confusion about the tax implications of receiving a bonus. Many employees are surprised when they get a bonus check that is significantly smaller than the original figure. All income, including bonuses, are subject to tax withholding.
What?s more, bonuses are considered ?supplemental income,? which is taxed differently than your regular pay, explaining why so many employees feel like their bonuses ended up so small. Tax time is confusing enough without adding additional supplemental income into the mix, so we?ve broken down the system for you, and it?s actually simpler than you might expect.
HOW ARE BONUSES TAXED?
How bonuses are taxed really depends on how the employer chooses to issue them. The IRS categorizes bonuses as ?supplemental wages,? which are treated differently than salary or ordinary wages. Other forms of supplemental wages include overtime, vacation pay, moving expenses, commissions, back pay, and severance or dismissal pay.
There are two ways employers tax bonuses: the percentage method and the aggregate method. Employers often choose to apply the ?percentage method? to supplemental wages, which charges a flat 25 percent fee to the entire payout. In this way, the income in singled out from your regular pay and taxed separately. So, if you get a $2,000 bonus from your employer, $500 is taken out for taxes and you pocket the remaining $1,500. This method is easy and simple for employers to implement and employees to understand, which is why it is so popular.
The ?aggregate method? is a more complex way to withhold supplemental income taxes, in which the bonus is folded into your overall taxable income. First, the employer adds the payout to your regular paycheck, then determines the normal withholding amount for the sum of both the regular income and bonus, subtracts what was withheld from the last paycheck, and withholds the rest from the bonus.
So, instead of being taxed at a flat 25 percent, you get taxed at what is probably a higher rate because the bonus is combined with your normal pay, which results in a larger overall tax obligation. TheStreet, a financial news website, offers an excellent example of how applying the aggregate method to bonuses can result in a higher tax withholding:
?If you make $2,500 a month but get a $5,000 midyear bonus, your withholding will be computed as if you received a single wage payment of $7,500 for the monthly payroll period. Then that $7,500 is annualized, or assumed to be part of your yearly salary. So if you earned $7,500 a month, you?d be making $90,000 annually versus $30,000. But at $90,000, your tax rate jumps to the 31 percent tax bracket vs. the 28 percent. Under this annualized method, you would end up taking home even less of your bonus because you?d be withheld at much higher rates.?
If your employer uses the aggregate method and your bonus is going to push you into a higher tax bracket, you may be able to defer your bonus into the 2015 tax year. This could give you more time to plan for the change in tax withholding or, if you think you?re going to make less in 2015, your tax withholding might not be affected at all.
Bonuses over $1 million are singled out and taxed differently than the two methods just described. Anything over $1 million is taxed at the highest rate of income tax allowed by federal law (currently 39.6 percent).
SMART WAYS TO SPEND YOUR BONUS
?If you don?t have an emergency fund and have debt: Put $1,000 of your bonus in savings and use the rest to pay off debt.
?If you don?t have an emergency fund and don?t have debt: Put your bonus in savings until you have enough to cover at least three months of living expenses.
?If you have an emergency fund and have debt: Pay off as much debt as possible.
?If you have an emergency fund and don?t have debt: Make an extra mortgage payment, fund an IRA or 401(k), open a brokerage account or start a 529 college savings account for a child.
WHAT NOT TO DO WITH YOUR BONUS
The absolute worst thing you can do with a year-end bonus is spend it without having a plan. Even if you are going to blow it all at the mall once the deposit hits your account, use some self-control, plan out your purchases and try to at least put a little away in savings. And if you want to skip the mall and invest your bonus instead, do your homework and map out a financial strategy. No matter how you decide to spend your bonus (or any other extra income) this year, just be deliberate and thoughtful about every financial decision you make.