Why Is My Bonus Taxed Higher?

Summary: Bonuses are considered supplemental income and are subject to different tax withholding methods than regular paychecks. While bonuses might appear to be taxed at a higher rate initially, various strategies like deferring payments, contributing to retirement accounts, and adjusting W-4s can help minimize their overall tax impact.

Have you ever had a sticker shock from a bonus check? That happens when you receive a bonus at work, and you are astonished to see how much was taken out for taxes. It can be frustrating, even upsetting, especially if you are not expecting such a big hit on that well-deserved bonus.

It’s important to learn how the IRS treats bonuses and why your bonus check seems to take a bigger tax hit than your regular paycheck. More importantly, there are a few things you can do to help manage the tax impact.

What is a bonus?

A bonus is like a financial pat on the back from your employer. It’s extra money you are given on top of your regular paycheck as a reward for hitting performance goals, sharing in the company’s profit or a year-end gesture of appreciation. Unlike your regular salary or hourly wages, bonuses are considered “supplemental income,” which is treated differently when it comes to taxes.¹

How are bonuses taxed?

How your bonuses are taxed depends on how you receive them. You usually receive your bonus in one of two ways–as a separate check or combined with your regular paycheck.

When you receive your bonus as a separate check, the IRS uses the percentage method to determine how much you owe in taxes.² When your bonus is included in your regular paycheck, your tax withholding is calculated using the aggregate method.

Let’s look at the differences between these two methods of how bonuses are taxed.

Percentage method

Often, employers will pay bonuses with a separate check. It’s easier for them to calculate the tax withholdings on a separate bonus check because it is taxed using a flat rate system. In other words, they apply a flat rate to your bonus amount to determine how much taxes to withhold. The flat withholding rate, set each year, is around 22% for bonuses up to $1 million and 37% for bonuses above $1 million. So, as an example, if you received a $3,000 bonus, the federal withholding taxes would be $660.

Aggregate method

When your bonus is included in your regular paycheck, figuring out the taxes on your bonus can be somewhat complicated. In this case, your employer uses the aggregate method to calculate tax withholdings. The aggregate method uses regular tax tables to figure out tax withholding on the total amount of your check–income plus bonus.

For example, if your regular paycheck is $2,000 and you get a $3,000 bonus, the tax withholding would be calculated on the total $5,000. This may temporarily put you in a higher tax bracket, which means you’ll be taxed at a higher rate than you usually are for your $2,000 paycheck.

However, this doesn’t necessarily mean you’re paying more taxes. When you file your tax return, the IRS considers your annual income and adjusts everything accordingly. If too much was withheld, you’ll get a refund.

How to minimize tax withholdings on bonuses

There are a few strategies you can use to try and reduce the amount of tax withheld from your bonus:

1. Defer to next year

Deferring your bonus means putting off receiving the bonus until a later date, usually within a different tax year. This is something you’ll need your employer to agree to. By deferring your bonus, you may be able to reduce the amount you’re taxed on in the current year, especially if you expect to be in a lower tax bracket in the next year. It’s important to note that while deferring your bonus can temporarily help reduce your taxable income, you’ll still need to pay taxes on it eventually.

2. Contribute to your retirement account

You can also delay paying taxes on your bonus by depositing it in a tax-advantaged account like a traditional IRA vs. 401(k) or Health Savings Account (HSA). These contributions can reduce your taxable income for the year, helping to lower your overall tax burden. The deadline to make contributions to tax-advantaged accounts is December 31 of the tax year, and there may be limits to how much you can contribute annually.

3. Take advantage of tax deductions

While many people take the standard deduction on their tax returns, you may benefit from itemizing your deductions. Deductions help lower your taxable income, which can reduce the amount of taxes you owe, including on your bonuses. Consult a tax professional to help you take full advantage of your options.

4. Change your W-4

By updating your W-4 (tax withholding form) with your employer and changing your withholding allowances, you can help ensure the right amount of tax is taken out of your regular paycheck. This can help lessen the impact of a large tax hit when you receive a bonus.

Help maximize your bonus: Keep more of what you earn

While it may seem like your bonus is taxed heavily, understanding how the IRS treats supplemental income can help you take control. Whether it’s taxed through the percentage or aggregate method, there are smart ways to help minimize the impact. Strategies like deferring your bonus, contributing to a retirement account, or adjusting your withholdings can help to ensure you keep more bonus and enjoy the benefits of your hard work.

FAQs

Q1. Are bonuses taxed differently than commissions?

No, bonuses aren’t taxed differently than commissions. The IRS considers both to be supplemental income, so they are taxed similarly. Like bonuses, commissions are subject to either a flat withholding rate of about 22% for amounts up to $1 million (the percentage method) or taxed in combination with your regular wages (the aggregate method). The main difference is in how your employer handles the payments.

Q2. How do you pay bonuses to employees without taxes?

Legally, employers can’t pay bonuses without withholding taxes from the amount. The IRS requires employers to withhold taxes on all taxable income, including bonuses. However, there are options on how employers can reward employees with less of a tax impact. Those options include additional time off or depositing bonuses directly into a tax-advantaged account, such as a 401(k) or Health Savings Account (HSA).

Q3. Should bonuses be on a separate check?

Employers typically decide the payment method for bonuses. There is no legal or regulatory requirement to pay bonuses separately or combined with regular paychecks. However, many prefer the separate-check method because it allows for more control over tax withholding on the bonus amount. If they decide to use the aggregate method, taxes are usually higher, but the employee will get back any overpaid taxes when they file their annual tax return.

Sources

1. H&R Block, Supplemental income tax explained, 2024
2. Empower, Bonus tax rate: How bonuses are withheld in 2024, 2024

Disclosures:

Registered Representatives offer securities through Mutual of Omaha Investor Services, Inc., Member FINRA/SIPC. Investment Advisor Representatives offer advisory services through Mutual of Omaha Investor Services, Inc.

Mutual of Omaha and its representatives do not provide tax and/or legal advice, and the information provided herein is general in nature and should not be considered tax and/or legal advice.

Not all Mutual of Omaha agents are registered representatives or financial advisors.

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