Bonuses, frequently given at the end of the year, are a popular "thank you" for a job well done, and smart business owners know they can build loyalty, helping retain the most productive employees. However, both owners and employees often misunderstand how taxes work with bonuses, leading to confusion and frustration. Fortunately, with some education and preparation, the situation can work out for everyone.
In brief, bonuses are income and are subject to relevant federal and state taxes — including FICA. Businesses must enter any bonuses on their employees' Form W-2s. However, when it comes to federal income taxes, the withholding is different from the regular paycheck.
The IRS allows the following two withholding methods. If the bonus is separate from the regular paycheck, an employer will typically use the percentage method, which means the 22% rate applies to everyone. This is an easy system for the employer. However, employees who are in a higher bracket may thus find that too little was withheld and they will owe money. Those in a lower bracket may find too much withheld, leading to a refund.
The aggregate method is more complex for the employer but may lead to a more accurate withholding: The employer combines the bonus into a regular paycheck and calculates the withholding as usual, based on the employee's Form W-4. Of course, employees are sometimes careless about updating this form, which may mean too much or too little is withheld. So it's always a good idea for companies to remind employees to review their Form W-4 information annually.
Still more special rules
Those are the basics, but other special rules may apply to further complicate the situation:
The bottom line? Both companies and employees should work with tax professionals so bonus time is a happy time for everyone.
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