Here's Why Your Bonus Is Taxed So High

Slice cakeShutterstockThe IRS takes a big piece of your bonus.

At one of my first jobs, I got an annual bonus.

I don’t remember the numbers. 

What I do remember, however, is how surprised I was to see how much less I received than the number I was told at my end-of-year review. Thanks, taxes. 

I know I’m not the only one mystified by the case of the missing bonus, so I reached out to CPA Lisa Greene-Lewis of TurboTax to find out why end-of-year bonuses seem to be taxed so high.

It comes down to what’s called “supplemental income.” Although all of your earned dollars are equal at tax time, when bonuses are issued they’re considered supplemental income by the IRS and held to a higher withholding rate.

It’s probably that withholding you’re noticing on a shrunken bonus check. Employers take taxes from your check in one of two ways:

The percentage method. This is the method your employer will use if, like I did, you receive your bonus money in a check separate from your paycheck. Your company simply taxes the money at a flat 25%, to keep things easy on their end. 

The aggregate method. This is the method your employer will use if your bonus is added on to a regular paycheck. Your bonus, plus your regular earnings, are taxed according to what you shared with your employer on your W-4. Because you’re receiving more money than usual, your employer will withhold more money than usual.

In fact, TurboTax provides a handy calculator that figures out how your bonus will be taxed using either method, so you can brace yourself ahead of time. Greene-Lewis says that in some cases, depending on your income and tax rate, you might actually get some of this money back in the form of a tax refund.

If your bonus is only a few hundred bucks, there isn’t much you can do about the taxes. If you’ll receive a considerable amount of cash, though, you have a few options.

“Maybe you can increase your retirement savings,” Greene-Lewis suggests, “or you can donate to your favourite charity and get a deduction there. If you own a home, you can maybe prepay your mortgage and get a bigger deduction, or prepay your property taxes.” While none of these options allow you to keep more money from your bonus, they do provide tax breaks that could offset the withholding.

Bain & Co. employees in their office. GlassdoorYour bonus minus taxes is still more than no bonus at all.

While some people get their bonuses in January or February, others receive them around the holidays. “A lot of time employers like to pay holiday bonuses in December because they’re able to write that off if their books close December 31,” Greene-Lewis explains.

If that’s the plan for you, and your bonus is big enough to push you into another tax bracket, you can also ask if your company will defer the payment of your bonus to the new year.

This comes in handy if you expect your income to decrease in the new year, or for your deductions to increase substantially enough to offset the taxes — like if you’re planning to buy a house.

While you might think, logically, that employees could be better served, tax-wise, by gradual bonuses paid over a series of paychecks or by a simple raise that tacks on some extra money year round, Greene-Lewis says that a company’s ability to pay bonuses is determined between the time they finish up their accounting for the year and when they officially close their books, and has to be paid before that year is closed. Because a company doesn’t know how much it can afford to pay until the last possible minute, employees are getting lump sums.

But if you’re going to get a lump of anything this holiday season, it might as well be cash.

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