Understanding Taxes on Year-End Bonuses

As the year winds down people (hopefully) are receiving their year-end bonus. It’s also at this time of year that I am oftentimes asked “I just got my bonus check and they took so damn much out in taxes. Why?”

Well let me try to clear this up.

There is generally some confusion as to how year-end bonus income is taxed. Many people mistakenly believe that the bonus they receive from their employer during the holiday season is taxed at a higher rate than regular income. Others believe that a year-end bonus could bump them into a higher income tax bracket, resulting in their being subject to a higher tax rate on their total income for the year. Fortunately, however, neither scenario is necessarily true.

Bonus Income is the Same as Regular Income

As far as the IRS is concerned, bonus income is the same as your regular income. Any bonus income that you receive is added to your W-2 income, and is calculated in the total income you report to the IRS on your federal tax return forms. Employers often treat bonus income differently in terms of how they withhold taxes from the payment. That is why some people have the mistaken believe that a bonus will increase their taxes.

While a year-end bonus may technically put you into a higher tax bracket, you must realize that since you are taxed on an incremental basis, you won’t be taxed at a higher rate for all of your earnings last year. So, for example, if you look at the
2015 Tax Brackets for taxes due April 18, 2016 (or April 19, 2016 if you live in Maine or Massachusetts) and your filing status is single, you’ll see that the 10% tax bracket is up to $9,225 in earnings. This means that if you earn $9,225, your tax rate is 10%, and if you earn more than that – let’s say $30,000 – you will be placed into the 15% tax bracket, meaning that you still pay 10% on the earnings up to $9,225 and then you pay 15% on the earnings from $9,226 to  $30,000. Therefore, your actual tax rate is not 15%, but rather a combination of the different rates for the tax brackets that you fall into throughout the year.

So, yes, it is possible that your year-end or holiday bonus can push you into a higher tax bracket, but that does not mean that you will pay more money on the income that you earned earlier in the year.

How Employers Handle Bonus Income

Another reason why people think that they will be taxed at a higher rate on the bonuses that they receive is because more money may be withheld by the employer for taxes.
However, it is all dependent upon the employee’s final income at the end of the year. A person who makes 90% of his income in bonuses compared to someone who makes 10% of his income in bonuses and earns the same amount of money with the same filing statuses and deductions will still actually pay the same taxes.

Regardless of which of the following three methods for withholding federal taxes from bonus income an employer uses, your bonus income and regular pay are added together and   reported the same on your income tax return. If you overpay taxes, you receive a refund; if you underpay, you will owe more money when you file:

  1. The bonus can be included in the employee’s paycheck. The sum of the regular paycheck and the bonus payment are added together, and the standard withholding is calculated. The amount of tax already withheld from the regular income payment is subtracted, and the difference is withheld from the bonus.
  2. The employer can elect to withhold 25% federal income taxes from the bonus, and 35% for any bonuses over $1 million.
  3. The bonus can be included in the employee’s paycheck with no difference between the two types of income, and taxes are calculated based on the total amount of the pay and bonus combined.

It may seem like your bonus check is being taxed more money than you are used to – and even cause you to fear receiving a bonus. While you may see more money withheld from your bonus pay than you are used to seeing from your regular paycheck, keep in mind that it will all even out when you file your income taxes.

Exceptions for Hedge Fund and Investment Managers

Hedge fund managers and other investment managers who receive bonuses are considered to receive “carried interest.” So if an investment manager receives a bonus from investment gains, they are taxed at a top tax rate of 23.8% (long-term capital gains rate topping out at 20% plus 3.8% net investment income tax), which is generally lower than their marginal tax rates that the rest of their income is taxed on.

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Bruce – Your Host at The Tax Nook

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