Everyone loves a bonus. Though not all companies issue employee bonuses, they can be a great way to recognize hard work, dissuade high performers from leaving, or just to give everyone in the company a piece of the pie.
The IRS wants its share of that pie, too. Processing bonuses is entirely separate from running regular payroll, as these special payments come with their own separate tax rules. So how, exactly, are bonuses taxed?
Why are Bonuses Taxed so Highly?
Payments that fall outside of regular wages, like bonuses, commission, and severance, are deemed “supplemental wages” in the eyes of the IRS. That means your year-end bonus or employee referral bonus is subject to higher taxes. If you’ve ever received or processed a bonus in the past, you’ll notice that it often displays as a separate line item on the employee pay stub. Bonuses are subject to Social Security, Medicare, and unemployment deductions, as well as additional federal and state taxes. The amount an employee's bonus is taxed depends on their tax bracket and what withholding method the employer chooses to implement. There are two approaches a business can use to tax an employee's bonus: the percentage method and aggregate method.
As with many things in life, there’s an easy and a hard way. Luckily for you, the easier way of processing bonuses often makes the most sense for both the payroll administrator and recipient.
The easy, or percentage method, applies one flat rate (25 percent) to the bonus—assuming it doesn’t amount to more than $1 million. Those very fortunate individuals are subject to a much higher rate, 39.6 percent. In addition to this flat rate, taxes like Social Security and Medicare will also apply. States also have their own tax rates for supplemental income. For that reason, recipients shouldn’t be too surprised to see a $5,000 bonus sink down to just about $3,000 in take home pay.
The Aggregate Method
The more complicated aggregate method is best described in steps:
1. Add the bonus amount to the employee’s most recent paycheck 2. Take the sum and determine what the regular federal withholding amount would be 3. Subtract the usual withholding amount from the combined withholding amount 4. Withhold the difference from the bonus
The above method is usually only favorable for low wage earners, and otherwise often results in bonus recipients actually paying a higher tax rate on their bonus. Most businesses tend to opt for the simpler percentage method, as it benefits both the administrator and the employee.
When in doubt, opting to use the percentage-based approach is the easiest way to process supplemental wages. Time and company size permitting, it might not hurt to just ask an employee what he or she prefers. Considering the number of bonus calculators available online, you may be surprised to find many of your employees are self-taught tax experts.