Knowing that you’re going to receive a bonus from your boss can be an exciting experience.
All your hard work is paying off and now you get a little financial incentive to keep up the good work.
However, when you receive your bonus paycheck, you may realize that it’s smaller than what your boss promised.
Did they make a mistake, or is it something else?
Here’s what you need to know about bonuses and taxes.
Why Are Bonuses Taxed So High?
Bonuses are classified as a different type of income.
The IRS views bonuses as supplemental income.
This classification puts bonuses under a different tax rate than your standard income.
Depending on the amount that the bonus is, different tax rates are applied to it.
It’s similar to your income in that, if you make a certain amount in a year, you fall into a certain tax bracket.
Employers can sometimes influence how high the tax rate is on the bonus, too.
They have two different ways in which they can take out the tax.
Most tend to use the percentage method.
It’s easier and faster.
With the percentage method, your bonus comes to you as a separate check from your paycheck.
Your employer withholds tax at a flat 22% for any bonus under $1 million.
If the bonus is above $1 million, then it’s taxed at the highest rate possible.
This rate varies from year to year.
The other method that the employer can use to tax your bonus is the aggregate method.
This method takes a bit longer to calculate and requires you to fill out a W-4.
If you find that your bonus is on top of your regular paycheck, then your employer is using the aggregate method to take the taxes out of it.
With the aggregate method, the employer will withhold tax both from your bonus and your regular earnings.
They do so according to the information they have on the Form W-4 that you submitted to them.
Since you’re earning more of an income than normal, you can expect more taxes withheld from it.
That said, you won’t earn less than what you’ve been earning already.
Your bonus just won’t be as high as the employer promised.
Bonuses receive a higher tax rate because they’re treated as supplemental income by the IRS, which carries a higher tax rate.
Can You Take Deductions From A Bonus?
If you’re worried about your bonus pushing you into a new tax bracket, then you may be looking for ways to mitigate the bonus by taking out deductions.
Deductions work by telling the IRS where your money is going.
As long as they agree with the deduction, you can basically tell them that your income isn’t as high as it appears.
As a result, you’ll have to pay less in taxes.
If you’re a standard W-2 employee, then this means your refund might be even higher since your taxes are already pulled out of your paycheck each time.
Here are a few deductions you might be able to take to offset your bonus come tax time.
1. Increase Retirement Savings
The IRS encourages workers to contribute to their retirement savings throughout their working careers.
They do so by offering a Saver’s Tax Credit.
This credit allows individuals making donations to their retirement savings to pay less money in taxes as a result.
To qualify, the individual has to be part of an employer-sponsored retirement program.
That means the individual should be part of one of the following programs:
- 457 Plans
- Traditional IRA
- Roth IRA
If you’re part of any of these programs, then you’re eligible to take the Saver’s Tax credit as long as you put money into your retirement account.
There are a few other stipulations as well.
You have to be above the age of 18 to take the credit.
You also cannot be a full-time student or a dependent of someone else.
If you qualify, then here’s how the credit works.
The credit rate that you receive depends on your adjusted gross income (AGI) and your filing status.
According to the 2022 tax rules, if you want to take the 50% credit, then your AGI if you’re married and filing jointly cannot exceed $41,000.
If you’re a head of household, then your AGI cannot exceed $30,750.
If you’re filing as single, then your AGI cannot exceed $20,500.
Besides 50%, you can also choose the 20% and 10% credit rates based on how much you put into your retirement savings.
Here’s an example.
Mary has an AGI of $19,200 and ends up contributing $800 to her 401(k) plan as well as $600 to her traditional IRA plan.
She wants to take the 50% credit rate.
Her credit amount ends up becoming $700.
The math is as follows:
$800 + $600 = $1,400.
$1,400 x 50% = $700.
The IRS will then apply a $700 credit to her taxes.
If you end up using your bonus to maximize your retirement savings, then you can report that when you do your taxes to receive the Saver’s Tax Credit and pay even less on your taxes.
2. Charitable Donations
You can also use your bonus to make a charitable donation, which can help you earn a tax deduction and credit.
The IRS wants to reward those who use their income to help make the world a better place.
They do this by reducing your taxes if you make a high amount of charitable donations compared to your AGI.
Simply donating $10 to St. Jude’s usually isn’t going to cut it.
To qualify for the deduction, the amount that you donated throughout the tax year needs to be higher than the standard deduction amount.
The standard deduction amount differs from year to year.
For 2022, the standard deduction for single filers is $12,950.
For married filers filing jointly, the standard deduction is $25,290.
For head of household filers, the standard deduction is $19,400.
If you’re a single filer, then you need to make charitable donations that total more than $12,950.
This doesn’t mean that you have to make one charitable donation greater than that amount.
It can be any number of charitable donations, but the total of your donations needs to be higher than the standard deduction amount listed for that specific year and filing status.
The benefit of donating to charity is that you can then claim up to 60% of your AGI as a deduction.
This can really help you save money each year with your taxes.
However, you need to ensure that the charity you’re donating to qualifies.
To set yourself up for success come tax season, there are a few things you should do.
First, you should know how much you’re going to donate to ensure you donate enough to get the deduction.
Then you need to research the charities that you want to donate to.
In particular, you need to donate to charities that are 501(c)(3) public charities or private charities.
Donations to this classification of charity are the only ones that the IRS will allow you to deduct from your taxes.
When making your donation, you should receive a receipt from the charity.
Hold onto your receipts and make a copy for your records.
When it comes time to do your taxes, you have the receipts to help you calculate how many donations you made, to where, and you have the proof if the IRS decides to audit your account.
Bonuses can be a great opportunity to donate to a charity.
Not only does it help a great cause, but you can also use it to save on your taxes through a charitable deduction.
3. Pay Your Mortgage Or Property Taxes
Another great way to use your bonus and bring your taxes down further is to pay your mortgage off a bit more or to prepay your property taxes.
Like other types of debt, your mortgage generates a certain amount of interest each year.
It’s the interest that you pay that you deduct from your taxes and not the principal from the mortgage, itself.
This is also true for other types of debt like student loans.
When you pay more for your mortgage, then you’re also paying more interest.
The IRS lets you deduct the interest you pay when you itemize your deductions for that tax season.
Keep in mind that you have to actually itemize your deductions.
You cannot take the standard deduction since this is essentially taking a lump sum to make the math easier.
There are also a few rules that apply to the mortgage interest deduction.
First, you have to be the owner of the home.
If you rent the home to tenants, you can only qualify for the interest deduction by also living in the home for at least 15 days or more than 10% of the time you rent it to other tenants.
There are also limitations on how much interest you can deduct.
The tax system places a $750,000 principal limit on loans for those who file married and jointly.
For single filers, that amount is cut in half.
This also includes cumulative loans.
Therefore, if you have two homes, both count towards the $750,000 principal limit.
Essentially, if the amount you owe exceeds $750,000, then you cannot take the interest deduction on the amount that exceeds it.
You can only take the deduction on the amount under $750,000.
That said, you can earn yourself a nice tax break by paying off your mortgage further with your bonus.
Not only does it bring you closer to being out of debt, but it can save you money on taxes, too.
This means that you might receive a higher refund as a result.
Why Do Employers Give Bonuses At The End Of The Year?
Bonus season tends to come hand-in-hand with the holiday season.
Some employees may wonder why they get their bonuses at the end of the year instead of throughout the year.
It’s because bonuses tend to come out after the company has done all its accounting for the year.
They usually start looking at their taxes around this time and determine their various budgets for the new year.
If they discover that their sales were lacking, then they may need to utilize their profits to increase that performance in the coming year.
Because of that, they’re never too sure how much they can allocate to bonuses until their year-end accounting is finished.
You might want to know when you’re getting your bonus because of your own taxes.
You may have some concerns that the bonus might push you into a new tax bracket.
When this happens, you end up having to pay more on your taxes because you’re taxed at a higher rate.
This can be a problem, especially if you know that you’re going to make less money next year than you did the previous year.
Because your current taxes are going to show that you earned enough to enter a new tax bracket, then the IRS will take more out of your income each paycheck at that new rate.
If you’re actually making less money, then you’re still faced with paying that new tax rate until you do your taxes again the next year to show your income has decreased.
To offset this, one thing you can try is to ask your employers to hold onto your bonus until the next year.
In this way, you don’t have to include the bonus in your taxes.
Instead, it will apply to next year’s taxes.
If you end up making less, then the bonus won’t push you into the next tax bracket, and you won’t lose a lot of money towards taxes.
Not all employers are able to do this, however, since they have a lot of financial reporting to do as well.
Still, if you’re worried about being pushed into a new tax bracket, then you can always ask them to delay your bonus.
Do You Get Your Bonuses Back Through Tax Refunds?
Perhaps one of the biggest misunderstandings about bonuses is that you don’t end up getting a bonus at all.
If anything, it pushes you into a new tax bracket, and you will owe more to the IRS.
That isn’t the case.
While your bonus does get a good chunk taken out of it initially, when it comes to tax time, the IRS goes through your income for the year.
They then recognize that your income didn’t increase by your bonus.
Rather, your income stayed the same, but you received a one-time bonus that increased one of your paychecks.
As a result, the IRS ends up giving you a decent tax refund.
The system thought that you were going to be in a new tax bracket because of the bonus.
However, once you file your taxes, the government sees that the bonus was a one-time payment rather than an addition to your overall income.
Your tax rate may increase by a percentage point or two, but in most cases, you will not find yourself pushed into a new tax bracket.
As a result, you’ll still be able to receive a tax refund since your taxes were withheld by your employer.
Is Earning A Bonus Worth It?
Since taxes bite into your bonus anyway, you may wonder if they’re worth it.
Bonuses are absolutely worth it.
It’s more money in your pocket at the end of the day.
Bonuses also allow you to get creative with your taxes.
You can use them to drive up tax deductions that can net you a higher tax refund.
You can invest in your home to increase your equity and potentially sell your house for a higher amount in the future.
You can use bonuses to start investing in the stock market and earn money passively.
Bonuses allow you to have a bit of extra money that can help you make changes in your life.
Bonuses receive a higher tax rate because they classify as supplemental income.
The IRS believes that the bonus adds to your overall income and charges you at a higher tax rate, initially.
However, when you do your taxes, the IRS then understands that it was a one-time payment and applies the correct tax rate to your account.
You can also use your bonus to earn yourself even more tax deductions which can earn you even more money in the long run.