Getting a bonus at work is always a reason to celebrate -- especially if you're looking at a nice chunk of extra money. But unfortunately, your ultimate payout may not end up being nearly as high as you'd expect. The problem with bonuses is that they're subject to a special federal income tax rate that can ultimately lower the amount you take home as actual pay. Furthermore, if your bonus payment is tacked on to your regular income, you might lose an even greater amount, depending on your tax bracket. Understanding how bonuses are taxed can help you plan accordingly and avoid disappointment when you do receive that check.
Special tax rules for bonuses
The money you receive in your regular paycheck -- whether it's weekly, every other week, or once a month -- is considered ordinary income and taxed based on the bracket you fall into and the number of exemptions you've claimed on your W-4. Bonuses, however, are considered supplemental wages, i.e., compensation received on top of ordinary earnings. As such, they're treated differently from a tax perspective.
There are a couple of different methods your employer might use for applying taxes to your bonus. The first is the percentage method, where a 25% flat tax rate is applied to any wages that are considered supplemental. Those megabonuses you see on Wall Street are taxed at an even higher rate -- 39.6% for any amount in excess of $1 million.
In the case of a $10,000 bonus, the percentage method would automatically reduce the ultimate payout to $7,500, but keep in mind that on top of that 25% rate, bonuses are also subject to Social Security and Medicare taxes, as well as whatever state taxes apply. It's therefore not unusual for a $10,000 bonus to translate into a $6,000 payout after all is said and done.
Then there's the aggregate method of taxing bonuses. Under this method, bonuses are added on to employees' regular paychecks, and recipients are taxed on the aggregate amount. Though many companies that pay bonuses employ the flat rate method because it's simpler and easier to track, the aggregate method is a perfectly valid means of applying taxes to supplemental income.
Don't spend that money until you get paid
Some people are told what their bonuses will be weeks or even months before receiving an actual check. If this happens to you, don't rush to spend that money. First of all, unless you're truly in a solid financial position, you should probably use your bonus money to do things like pay off debt or save for retirement or emergencies. But if you are going to spend that money on the things you want and don't necessarily need, make sure you account for the taxes that will inevitably be applied to your bonus. In other words, if your employer says you'll be receiving a $5,000 bonus at the end of the year, assume that you won't actually get more than $3,000 when that payment hits your account. The last thing you want to do is overspend and wind up in debt because you miscalculated the way your bonus would be taxed.
Your money won't necessarily be gone for good
Though it's disheartening to see such a large portion of your bonus disappear due to taxes, keep in mind that you may get some of that money back when you file your return. If, for example, you have a large number of deductions, then some of the taxes withheld from your bonus could come back to you in the form of a refund. While you shouldn't necessarily plan on getting more out of your bonus than what appears in your paycheck, don't despair, either: Your total tax burden for the year will work out to whatever it's supposed to be.
Losing a significant chunk of your bonus to taxes is a definite bummer to say the least. But before you feel too sorry for yourself, remember: It's a far better option than getting no bonus at all.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.