Getting a bonus is great news, and while there’s an abundance of advice around how to spend (or save) bonus compensation, there’s less coverage about something arguably more important: taxes. The way bonuses are taxed can sometimes surprise folks, so we put together a guide to help you prepare.
How bonuses are taxed
The IRS taxes the majority of bonus compensation as ordinary income. The exception to that is stock options, which have more complex rules. For the purposes of this article, we’ll look at how cash bonuses and restricted stock units (RSUs) issued to you during the calendar year count as taxable income within that year.
When it comes to bonuses, the date they are paid is a key consideration. If your company pays you a cash bonus on December 31, it counts toward that year’s income, even if you don’t cash the check until January. This is also true for RSUs: The IRS taxes you based on the value of your shares the day they vest, regardless of whether you hold them or sell them.
How employers handle bonuses
The first tax surprise around bonus compensation comes down to employer withholding. When your employer pays your bonus, they will generally withhold a certain percentage, similar a standard paycheck. How much an employer withholds depends on your Form W-4, plus current IRS and state tax guidelines.
For standard wages, the IRS guides employers to withhold a portion of your pay based on your anticipated tax bracket. Employers must also withhold money for Social Security and Medicare. (You can check current income tax brackets at IRS.gov.)
For supplementary wages like bonuses, however, the withholding rules are different. The IRS tells employers to withhold 22% of supplementary income up to $1 million (and 37% of any supplementary income beyond that). Many states have different withholding rules for this type of income as well. This guidance does not always accurately reflect the tax you will likely owe on your bonus (ordinary income tax).
While some employers tax bonus payments the same as your base income when it comes to withholding, many do not. If your employer uses the supplementary income guidelines and your marginal tax rate is above 22%, there’s a good chance you will owe additional tax on the bonus paid to you. It’s important to plan for that.
Watch our video explainer on how supplementary withholding rules may affect RSUs, specifically.
Tax planning and bonuses
Bonuses come with a second potential tax surprise. Since your bonus counts as ordinary income, a large enough bonus could bump you into a different tax bracket and affect your marginal tax rate.
Withholding calculations are based on your Form W-4, but, unless you specifically seek to adjust the amount that’s withheld, your employer usually uses your base salary for the calculations.
If you’re doing back-of-the-envelope math trying to calculate your bonus after tax, think of it with brackets in mind. The U.S. tax system is progressive, so if your bonus pushes you into a higher tax bracket, any income above that threshold would be taxed at the higher rate.
Once you have a rough sense for what the ordinary income tax would be, you can look at how much was actually withheld and have a better understanding of whether you need to set aside any additional money.
Of course, this is a vast simplification, and you may have additional income considerations beyond your salary and bonus—for instance, your spouse’s income if you’re married and filing jointly.
We recommend Quorum clients work with a tax professional to address these issues, as they’ll be able to provide a tax plan and withholding strategy customized to your personal situation. They may recommend strategies to lower your taxable income, such as funding a pre-tax retirement account like a 401(k), using other employer benefits such as deferred compensation if you have it, or a charitable giving plan.
If you have questions about how bonus compensation fits into your overall financial plan, contact us to discuss.
Disclaimer: The subject matter in this communication is educational only and provided with the understanding that neither Sanctuary Wealth or Quorum Private Wealth are rendering legal, accounting, investment, or tax advice. You should consult with appropriate counsel, financial professionals, or other advisors on all matters pertaining to legal, tax, investment, or accounting obligations and requirements.
