How are bonuses taxed?

A bonus check is the cherry on top of a job well done. More than extra cash, it’s a tangible recognition of dedication and hard work. Supplemental income on top of a regular salary can be a powerful motivator that keeps top talent engaged and committed to their role. 

As much as bonuses bring joy and work satisfaction, there’s another aspect to consider—their impact on employees’ paychecks and the tax liability that follows. In this guide, we’ll explain how bonuses are taxed. 

What’s a bonus?

A bonus is an additional payment or reward given to an employee in addition to their regular salary or wages. Typically, employers use bonus pay as an incentive or recognition to motivate workers for exceptional performance, meeting strategic targets, or contributing to the organization’s overall success. Some total compensation policies might also offer signing bonuses to attract top talent or retention bonuses and holiday bonuses to retain them. 

Employers typically deliver bonus payments in cash—direct monetary payments added to a worker’s paycheck. Alternatively, bonus pay can come via stock options, which allow employees to purchase company stock at a predetermined price, or profit sharing (i.e., a fixed percentage of the company’s profits). 

Although many call them bonuses, the Internal Revenue Service categorizes these payments as supplemental wages—compensation that falls outside the scope of an employee’s regular salary. Bonus pay is lumped alongside other supplemental wages, including commissions, severance pay, overtime pay, and tips.

How are bonuses taxed?

In the United States, employers generally withhold taxes on bonus payments just like they withhold taxes on regular pay. However, some bonuses are taxed differently depending on how they are paid out and classified by an employer. Here are the two main methods for withholding taxes: 

1. The percentage method: Employers who identify a bonus as supplemental wages separate from your regular paycheck automatically withhold taxes at a flat rate of 22%. However, bonuses are taxed higher if they exceed $1 million in a tax year. Everything over the first $1 million has a bonus tax rate of 37% withheld for taxes. Employers must use the percentage method if an employee receives more than $1 million in supplemental wages in a calendar year.
2. The aggregate method: When bonus payments are included with regular wages on a single paycheck, payroll taxes can be withheld on the entire amount rather than applying a separate bonus tax rate. The aggregate method is commonly used for commission-based jobs where supplemental pay is a regular part of an employee’s salary. 

Employees may be surprised to receive a bonus check with a lower number than what their employer promised. The discrepancy often stems from employers withholding payroll taxes to protect employees from unexpected tax liabilities come tax season, as bonus payments are subject to Social Security and Medicare taxes.

Although employees get less money up front, they might be subject to a refund later, depending on their tax situation and withholding allowances specified on their W-4 forms.

On the other hand, independent contractors should set aside a portion of their supplemental pay to cover annual taxes, including Social Security taxes and Medicare contributions. 

Are all types of bonuses taxable?

The IRS gets a cut of cash or equivalent bonuses (e.g., gift cards). However, federal tax generally doesn’t apply to fringe benefits—gifts or rewards with an insignificant monetary value. These include items like:

• Outings, meals, or lodgings
• Event tickets
• Holiday gifts or flowers
• Money for meals or transport for overtime work

Include non-taxable fringe benefits in your total compensation package to keep employees focused on strategic performance goals and targets. Like cash, they’re tangible rewards that demonstrate care and recognition.

However, employers should carefully determine whether a fringe benefit or bonus is taxable. Often, the frequency and monetary value of the fringe benefit will decide if taxes must be withheld.

How to reduce the tax impact of a bonus

Ultimately, the employer is responsible for withholding the correct amount of taxes from a bonus check. Although you can’t avoid paying taxes on a bonus payment altogether, there are options to reduce your tax bill. 

If you want to know how to avoid taxes on a bonus check, here are a few strategies: 

1. Check your W-4 form

Bonuses can push you into a higher tax bracket, increasing your tax liability. Review your W-4 form, which stipulates how much federal income tax is withheld from regular paychecks. If you anticipate a bonus, use the IRS Tax Withholding Estimator tool to determine whether you must edit your W-4 withholding allowance to avoid a higher bill come tax time. 

2. Use your bonus wisely

There’s nothing wrong with using your bonus to treat yourself; you deserve a fancy spa weekend or a new phone. However, consider using your bonus strategically to reduce your taxable income. Contributions to a 401(k), IRA, or Health Savings Account (HSA) might qualify you for tax deductions when you file your taxes. Confirm that 401(k) contributions are made with payroll deductions by year-end to qualify for a tax deduction.

3. Request a deferred payment

If a bonus payment might push you into a higher tax bracket, you may be able to defer it to the following year. If you anticipate a lower income (because of retirement) or reduced pay (due to unpaid leave or fewer hours), a deferral can help maintain your anticipated yearly income. Employers aren’t required to accommodate deferred bonus payment requests, but it never hurts to ask. 

4. Pay out-of-pocket medical expenses

You may be able to lower your tax bill by using a bonus to pay non-reimbursable out-of-pocket medical expenses. Expenses must be itemized and equal more than 7.5% of your adjusted gross income (AGI).

Not all medical expenses qualify for tax deductions. Although dental care, prescription medications, and some medical supplies typically apply, you should consult a tax specialist to determine which healthcare expenditures can be deducted from your total tax bill. 

Boost compensation and payroll for a better employee experience 

So, you built a global team and want to reward them for all their hard work. Determining how bonuses are taxed safeguards your team from surprise tax liabilities that soil the benefits of a little extra cash.

Taxes can be complex, and mistakes may come with costly penalties. Fortunately, Oyster can help streamline payments and bonuses for your global team. Our international employment platform offers Global Payroll support to help you maintain compliance and boost the employee experience for your workers worldwide.

About Oyster

‍Oyster is a global employment platform designed to enable visionary HR leaders to find, engage, pay, manage, develop, and take care of a thriving distributed workforce. Oyster lets growing companies give valued international team members the experience they deserve, without the usual headaches and expense.

Oyster enables hiring anywhere in the world—with reliable, compliant payroll, and great local benefits and perks.