Year-end bonuses: they are the monetary gifts that employees eagerly anticipate as a reward for their hard work and dedication throughout the year. However, when the much-awaited bonus finally arrives, it may seem smaller than expected. One of the major culprits behind this phenomenon is tax withholding. In this article, we will delve deep into the intricacies of tax withholding on bonuses, exploring how it affects your take-home pay and what you can expect when filing your annual tax return.
Unlike regular wages, bonuses are categorized as “supplemental” income by the Internal Revenue Service (IRS). Consequently, they are subject to different tax withholding rules. Tax experts reveal that most employers withhold tax from bonuses at a flat 22% federal rate. While this rate is applicable to a sizable portion of the population, individuals with a federal marginal income tax rate lower than 22% may witness a substantial reduction in their year-end bonus due to tax withholding.
Jeremiah Barlow, the head of wealth solutions at Mercer Advisors, highlights that individuals with a taxable income up to $44,725 and married couples filing jointly with an income up to $89,450 fall into this category. Astonishingly, IRS statistics from 2020 indicate that nearly half of individual tax returns, approximately 81 million in total, were in a marginal income tax bracket below 22%.
Tax withholding on bonuses extends beyond federal taxes. State and local taxes also play a significant role in reducing the size of your year-end bonus. For instance, employers in California withhold supplemental wages at a state rate of 10.2%. Consequently, California residents may see their bonuses being subject to a combined state and federal tax rate of 32.2%, according to Barlow. Moreover, bonuses are usually subject to additional Social Security and Medicare payroll taxes, amounting to 6.2% and 1.45%, respectively.
Matthew Fleming, a certified financial planner and senior wealth advisor at Vanguard, warns of the potential for a significant portion, around 40%, of your bonus being withheld due to various taxes. To compound matters, employers must withhold a flat 37% from bonus amounts exceeding $1 million. Fortunately, companies have an alternative withholding option: combining the bonus with regular paychecks. This approach allows employees to be taxed at their usual income-tax rates, potentially resulting in a higher take-home bonus amount.
If you find that your bonus seems smaller due to tax withholding, fear not, for there may be a silver lining. The excess amount withheld by your employer can be refunded to you when filing your annual tax return. Fidelity Investments assures that any refund owed to you will be equivalent to the extra amount withheld from your year-end bonus. Consequently, receiving a tax refund can help alleviate the disappointment caused by the seemingly diminished bonus.
However, as with any coin, there is another side to consider. Higher earners, particularly those within the federal income brackets of 24%, 32%, 35%, or 37%, may find themselves owing additional money to the IRS during tax time. This scenario arises when their bonus is withheld at the flat 22% federal rate, which may not align with their actual tax bracket. Jeremiah Barlow cautions that a substantial bonus, such as $200,000, has the potential to push someone into a higher tax bracket, resulting in a significant tax liability. Therefore, it is essential not to assume that the amount withheld from your bonus was sufficient to cover your tax obligations.
Tax withholding can significantly impact the size of your year-end bonus. Understanding the unique treatment of bonuses by the IRS and the role of state, local, and payroll taxes is crucial in managing your expectations. While the prospect of receiving a tax refund is encouraging, it is essential to consider the potential owing for higher earners. By equipping yourself with this knowledge, you can navigate the complexities of tax withholding and make informed financial decisions when your year-end bonus arrives.
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