Why Bonuses Are Heavily Taxed
You’ve probably wondered why your bonuses are so heavily taxed. It’s all in the tax law. There are two methods to determine bonus withholding. One method is called the Percentage Method; the other is the Aggregate Method. Which method is used to tax your bonus is determined at the state level.
The Percentage Method of Taxing Bonuses
The Percentage Method is not very favorable to the average taxpayer. A flat tax of 25% at the federal level and a flat state percentage (I know it happens to be 5.75% in North Carolina) will be withheld from your bonus. It doesn’t matter if you are in a low tax bracket or if you usually get to keep 90% of your check. This is a flat tax, regardless of your tax bracket. Your only recourse in this situation is if you have a guaranteed bonus coming your way, you can increase your withholding allowances during the year. This means your regular paychecks will have less income tax withheld, to offset the high tax withholding on your bonus.
Another alternative is to wait until you get your bonus, and then increase your withholding allowances so that less tax is withheld the rest of the year. These are difficult strategies to implement though, since most bonuses come at year-end, and you do not want to risk under-withholding for a bonus that might never appear.
The Aggregate Method
The Aggregate Method can be a little bit better for your bottom line. In many states, the aggregate method is allowed, which means the tax withheld on your bonus check is based on your wages and tax withholding to-date. This basically means it will be calculated like any regular paycheck. Regardless, this method will still take a big bite out of your bonus. The reason is that often payroll software does not recognize that a bonus is a one-time payment. So the payroll software might assume that your $1,000 bonus check is really a recurring amount that will push up your annual income much higher.
For the one bonus, it may assume it needs to withhold a lot more because the software suddenly thinks you are in a much higher tax bracket and that you need to be taxed at a higher rate. For smaller bonuses, many employers don’t even realize there is a “method” so faulty software calculation is probably the biggest bonus problem for most of us.
Make Sure You Pay Your Taxes on Your Bonus
Even if your employer figures out your bonus correctly, the fact is, a bonus is usually a large amount compared to your regular paycheck. Let’s face it; a bigger check is going to need more taxes withheld. The taxes are simply magnified. All of these factors lead to you getting a smaller bonus check than you expected.
Maybe your federal tax rate is 35%, but your company only withheld 25%. To ensure you pay enough in, simply ask your employer to withhold more taxes from your bonus checks. Setting up your 401(k) so that 100% of the bonus goes into the plan — but most employers’ 401(k) plans have a maximum contribution percentage, but you can politely ask HR to increase it to 100% so people can catch up at the end of the year.
Finally, if you aren’t into spending a lot of money on your taxes, consider getting a copy of TurboTax. If your situation is simple, it will help you correctly estimate your tax rate. If your rate is complicated or you own a ton of assets or a company, it is probably best to locate a good accountant.