Getting a bonus at work is great news and means a lot of extra cash in your wallet. But, when your bonus check comes through, you may find it's a lot smaller than expected. That can happen because bonuses are typically taxed differently than your regular income.
If you're shocked to find your bonus check is only a fraction of what you were told it would be, read on to find out why so much money was taken out of your check for taxes.
How are bonuses taxed?
For most employees, every time you're paid, the company you work for withholds some of your income and sends it to the Internal Revenue Service. This is necessary to comply with pay-as-you-go rules that require income taxes to be paid as income is earned.
When you get a bonus, the IRS has special rules for how that bonus should be taxed. The process used to determine how much is withheld for taxes depends on whether your bonus is given to you as a separate check or is simply added to your regular paycheck.
If your bonus is provided to you in a separate check, it's considered supplemental wages. Supplemental wages were taxed at a flat 25% tax rate in 2017 and will be taxed at a flat rate of 22% in 2018, provided the bonus is under $1 million. For many employees, this 22% or 25% flat rate is much higher than the typical withholding rate.
If your bonus is simply added to your standard wages in one big paycheck, your employer will use standard withholding tables to calculate tax withdrawals. However, because the income is higher with the bonus included, taxes will be withheld at a higher rate.
For example, if you're a single person who receives a biweekly paycheck valued at $509 to $1,631 after subtracting allowances, your employer normally withholds $36.70 plus 12% in 2018.
If your bonus pushes you above the $1,631 threshold, so your income after subtracting allowances is between $1,631 and $3,315, your employer is required to instead withhold $171.34 plus 22%. That's obviously a lot more money.
What if your bonus increases your taxes?
In some cases, if your bonus doesn't actually increase your taxable income by much, some extra taxes that were withheld will come back to you in your refund.
However, a big bonus could mean you get pushed into a higher tax bracket, owing tax at a higher rate on some or all of that bonus income. Even if this doesn't happen, you'll still have to pay taxes on the extra income you earn.
One great option is to bank your bonus. Contribute some or all of the bonus money into a 401(k) or a traditional IRA. Not only will you avoid a bigger tax bill, but you'll also set yourself on the path toward a more financially secure retirement.
If you can't save your entire bonus and you receive it in December, you may also want to ask your employer to wait and give it to you in January.
This would be beneficial if you plan to earn less the next year, or if you'll be able to increase your retirement savings to offset the added income. If your situation will be the same next year, waiting to get your bonus wouldn't help you much, other than deferring your tax increase for a time.
Be prepared for bigger taxes on your bonus
If you find out you're getting a bonus, don't count the money before it comes. Be prepared for the added taxes and, ideally, make the decision to invest the money you receive so you can avoid owing more to the IRS.
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