Why are bonuses taxed?

First and foremost, bonuses are taxed because they are considered taxable income. But the IRS also considers bonuses to be supplemental wages. Essentially, supplemental wages are types of wages—e.g., overtime, commissions, etc.—that aren't regular wages.

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For some fortunate workers, December means that a year-end bonus is on the way. That can be considered good news (especially since some companies are cutting budgets, laying off workers, or scrapping bonuses altogether). But, people are often surprised when the amount of money that they receive from a bonus is much less than they expected. That situation—where a big chunk of money seems to be missing from your bonus pay—is due to federal tax withholding and so-called bonus tax rates. Even though you can’t change bonus tax withholding, it is helpful to understand how bonuses are taxed so that you know how much money to reasonably expect. Additionally, knowing how much bonus pay will arrive in your account, can help with year-end tax planning. That might involve navigating tax changes for 2022, and trying to offset income through tax deductions and tax credits.

How a Bonus Is Taxed: Why Are Bonuses Taxed So High?

When you see that the amount of your bonus check or direct deposit is less than your employer-promised bonus amount, it’s most likely because your employer has withheld taxes from your bonus. (Although, it is always important to double check the amount of your bonus as described by your employer.) First and foremost, bonuses are taxed because they are considered taxable income. But the IRS also considers bonuses to be supplemental wages. Essentially, supplemental wages are types of wages—e.g., overtime, commissions, etc.—that aren’t regular wages. When your employer pays supplemental wages, they are supposed to follow payroll tax rules and withhold a portion of those wages (in this case, your bonus), for taxes. The amount that is withheld from your bonus depends on the withholding method that your employer uses, which depends, in part, on the amount of your bonus, and how your bonus is paid.

Bonus Tax Rate: How Bonus Tax Withholding Works

Percentage Method: The first supplemental wage tax withholding method is called the percentage method. This method is typically used when your bonus check is issued separately from your normal paycheck. The percentage method means that if your bonus is less than $1 million, your employer automatically withholds a flat 22% from the bonus for tax. (If you earn commission or have ever received severance pay, you may also have had the flat 22% withheld because those types of pay are also usually considered to be supplemental wages.) So, if you’ve been told that you are receiving a $5,000 bonus, and your employer uses the flat percentage method, they should withhold at least 22%, which based on this example would be $1,100. If your bonus exceeds $1 million, the flat percentage withholding would be 37% of the amount of your bonus that exceeds $1 million. Thirty-seven percent correlates to the top federal income tax rate.

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Aggregate Method: The other method for withholding from supplemental wages is the aggregate method. This is typically used when your employer pays your bonus money along with your regular pay in a single payment. Under this method, your employer withholds tax in accordance with a formula based on the information that you provided on your W-4 Form. The aggregate withholding method can cause some confusion and frustration for people. That’s because your regular pay and bonus pay are combined, as a lump sum. As a result, the amount of tax taken out from the check that includes your bonus pay, is higher than what you’re used to with your normal paycheck on your regular payday. Keep in mind that other normal income, and payroll, taxes (e.g., state taxes, Social Security taxes, etc.) are also withheld.

Can You Avoid Paying Taxes on a Bonus?

Because your employer is required to withhold, you can't avoid the tax on your bonus. But it can understandably be frustrating to receive compensation for a job well done and then find that much of that money goes to taxes. With that said, if you’re curious about how much your bonus payment might impact your taxes, the IRS has a calculator that can help estimate your withholding before you file your tax return. And, when you file your federal income tax return, it turns out that too much tax was withheld (based on your income and tax rate), you could look forward to a tax refund. On the other hand, if you’re worried that your bonus will be large enough to bump you into a higher income tax bracket, you could consider deferring your bonus to a new tax year. For example, if your company plans to pay your bonus now (i.e., in December), and you expect to have less income next year, you may be able to ask if you can have the bonus payment deferred until 2023. You might also be able to offset your bonus and other taxable income with some year-end tax moves. Tax deductions for donations to charity or contributions to your retirement savings account, can sometimes reduce your tax liability. But remember: December 31 is the deadline for making many of the key contributions for tax purposes that might help offset your year-end bonus.

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