You may be expecting a bonus from your employer at the end of the year or at the end of the busy season for your industry. If you've received a bonus in the past, you may have noticed that your employer's withholding for federal taxes on bonuses seems higher than ordinary withholding. You might also have heard that you can avoid federal withholding entirely by filing a W-4 claiming you're exempt from withholding. This was the case at one time, but often taxpayers who did this were unable to pay the taxes owed on their bonus income once April 15 rolled around. For this reason, the IRS implemented rules requiring withholding from bonus income and setting forth specific rules on how much must be withheld. It's no longer possible to file exempt from withholding for bonus income.
Tax Rates on Bonus Income
The good news is that bonus income isn't actually taxed at a higher rate at the federal level. The higher rate of withholding might make you think otherwise. However, on your tax return, your bonus income gets lumped together with your wage or salary income and is taxed according to the same rules. If you have more taxes withheld than you actually owe, you get a refund for the difference.
Withholding Is Required
Your employer doesn't have a choice about whether to withhold from your bonus income. IRS rules not only require withholding but specify allowable methods for determining the amount to be withheld. Your employer's only choice is which method to use. In addition, the law requires your employer to withhold money from your bonus income under the normal rules for both Medicare and Social Security.
Highly Compensated Employees
Special higher withholding rates apply to employees with supplemental wages over $1 million in a year. Supplemental wages includes bonus income, as well as commissions, payment for accrued sick leave, back pay and severance pay. For these employees, the IRS requires that 35 percent of the supplemental wages be withheld for federal income taxes. This rate is required because it's assumed that all this income will be taxed at the highest marginal rate.
For most employees, the employer may choose between two withholding methods for supplemental wages, including bonus income. The simplest is to withhold at a flat 25 percent — no other percentage is allowed.
The second method is more complicated but may result in lower withholding. Under the second method, the employer treats the bonus income as part of the same payment as the regular wage payment. The employer figures out what the total withholding would be under the normal withholding rules, subtracts the amount already withheld from the regular wage payment and withholds the difference from the bonus income.
Some employees can file as exempt from regular withholding because they had no tax liability in the previous year and expect no tax liability in the current year. This exemption doesn't cover withholding from bonus income, so even exempt employees aren't completely exempt. However, for these employees, employers must use the second method, which should result in lower or even no withholding on bonus income.