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Here is a breakdown of how bonuses are taxed.

Supplemental wages

The IRS considers bonuses to be “supplemental wages.” A supplemental wage is money paid to an employee that isn’t part of his or her regular wages, according to the IRS. In general, bonuses of any kind, including signing bonuses and severance pay, fit into the supplemental wages category. Other examples of supplemental wages include: Accumulated sick leave. Certain commissions. Overtime pay. Prizes and awards. Back pay. Reported tips. Retroactive pay increase. Payments for non-deductible moving expenses Certain forms of equity compensation (like restricted stock units and exercises of nonqualified stock options)

How are bonuses taxed

Just as your employer holds back a portion of your regular paycheck to prepay your taxes, it must take money out of your bonus check, too. These funds are sent to the IRS on your behalf. This process is known as . When it comes to bonuses, employers are allowed to calculate your tax withholding in one of two ways: the percentage method or the aggregate method. Wages, income, credits — what does it all mean? Become a tax pro in 15 minutes or less with .

The percentage method

The percentage method, also called the flat rate method, is the easiest way for employers to calculate taxes on a bonus. It often results in more money in your pocket, at least initially. When an employer taxes your bonus using the percentage method, it must identify the bonus as separate from your regular wages. The withholding rate for supplemental wages is 22 percent. That rate will be applied to any supplemental wages like bonuses up to $1 million during the tax year. If your bonus totals more than $1 million, the withholding rate for any amount above $1 million increases to 37 percent. In addition to the 22 percent federal tax, you’ll also pay Social Security tax (or FICA) and Medicare tax. Depending on where you live, state income tax may also apply. The current combined Social Security and Medicare tax rate is 7.65 percent. The current Social Security tax rate is 6.2 percent for employees. In 2021, you will pay FICA taxes on the first you earn. This is known as the Social Security wage base limit. The limit was $137,700 in 2020. The Medicare tax rate is 1.45 percent and no wage base applies. Not only is there no limit on Medicare taxes, you’ll pay an extra 0.9 percent if you earn more than $200,000 per year.

Percentage method examples

Below are two examples of how the percentage method works. Because FICA and Medicare tax are based on total annual earnings, they’re not included in these examples. Bonus amount $10,000 $1.5 million Federal tax $10,000 X 22% = $2,200 federal income taxes withheld $1 million X 22% = $220,000 $500,000 X 37% = $185,000$220,000 + $185,000 = $405,000 federal income taxes withheld Remaining bonus (before FICA and Medicare taxes) $7,800 $1,095,000 Note: If your supplemental wages for a year total more than $1 million, your employer must use the flat rate method and calculate your bonus withholdings (over $1 million) at 37 percent.

The aggregate method

Sometimes employers pay bonuses alongside regular wages. In this situation, your employer must use the aggregate method to calculate the initial tax withholding on your bonus. The result is often a headache for the employer who is figuring the tax withholdings and possibly more money withheld from your bonus. With the aggregate method, the tax withholding on your bonus is calculated at your regular income tax rate. The withholding rate is based on your . Often, when taxes on wages plus bonuses are calculated together this way, your initial tax withholding is higher.

Aggregate method example

Imagine your typical monthly salary is $6,000. Your tax withholding would be based on an annual salary of $72,000 ($6,000 X 12). That income amount would put you in the 22 percent federal tax bracket (assuming you file your tax return as single or head of household). Continuing with this example, your employer one month pays you a bonus of $10,000. The employer gives it to you alongside your regular $6,000 salary but identifies it as a bonus. Your monthly income climbs to $16,000 for the month at hand. Using the aggregate method, your employer would multiply $16,000 by 12 months. This would cause the tax withholding on your bonus to be calculated as if you were earning $192,000 per year, bumping you up to the 32 percent tax bracket. The employer would subtract the taxes already withheld from your last paycheck and take the remainder out of your bonus amount.

Exception to the rules

The IRS will expect its cut of any bonus you receive. Even if you receive your bonus in cash, gift cards, a vacation, or some other benefit, you’ll generally have to pay taxes. The exception to this rule is if your bonus can qualify as an employee achievement award. You might be able to avoid paying federal income taxes under the following conditions: The award isn’t cash, a cash equivalent (such as a gift card or money order) tickets to events, vacations, stocks, bonds or other prohibited items. The award is tangible personal property. The total value of the award doesn’t exceed $1,600.

Tax withholdings aren t the end of the story

The method your employer uses to calculate the federal withholding on your bonus can have a big impact on your take-home pay. Still, you won’t know how much you actually owe the IRS until you file your tax return the following year. If the tax withholding on your bonus turns out to be higher than necessary, you might receive a tax refund for overpayment. On the other hand, if too little money was withheld from your income throughout the year, you could wind up owing the IRS. You can reduce the risk of owing the IRS money by reviewing your W-4 withholdings. The is a good place to start. Also, if you receive a large bonus or your financial circumstances change, it may be best to talk to a tax professional for advice.

Lowering your tax withholding on a bonus

Want to lower the amount of taxes withheld from your bonus? Consider asking your employer to pay your bonus separately from your regular paycheck. From there, you can see if your employer will calculate your tax withholding at the 22 percent flat rate the IRS allows for supplemental wages.

Learn more

SHARE: Kay Bell Lance Davis is the Vice President of Content for Bankrate. Lance leads a team responsible for creating educational content that guides people through the pivotal steps in their financial journey. Chloe Moore, CFP, is the founder of Financial Staples, a virtual, fee-only financial planning firm based in Atlanta and serving clients nationwide.

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