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.
One key point to focus on there is the date. 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 are issued (or paid) to you, regardless of whether you hold them or sell.
How employers handle bonuses
The first tax surprise around bonus compensation is the way employers handle withholding. When your bonus is paid out, the employer will generally withhold a certain percentage, similar to the way it withholds tax from your regular 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.
Some employers will pay bonuses out as if they are ordinary income and use the same withholding guidelines as they would with any other paycheck. Many employers, however, use the supplementary income guidelines.
That means that if your marginal tax rate is above 22%, there’s a good chance that you will owe additional tax on any bonus paid to you. It’s important to plan for that.
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 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.
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.
