Holiday Bonuses: How The IRS Treats Them in Terms of Taxes

December 9, 2013
The IRS treats bonuses as supplemental wages that must be reported on a tax return.

The IRS treats holiday bonuses as supplemental wages that must be reported on a tax return.

The holidays are here, and some companies are handing out holiday bonuses to their employees during this festive time of year. So how does the IRS actually treat bonuses in terms of taxes? 1-800Accountant explains:

In basic terms, bonuses are classified by the IRS as “supplemental wages.” This means they are not treated quite the same compared to traditional income. It also does not matter what time of year they are given out, whether it be around the winter holidays in November and December or in the middle of the summer. In the eyes of the IRS, supplemental wages are defined as compensation paid in addition to the employee’s regular wages. This type of income often includes severance/dismissal pay, vacation pay, back pay, bonuses, overtime, moving costs, taxable fringe benefits, and payments for commissions.

There are two basic routes that can be taken for taxing bonuses. One of these is known as the “percentage method.” The other is referred to as the “aggregate method.” Here is a breakdown of how each method works:

The Percentage Method: This method is fairly straightforward. In basic terms, the IRS taxes any bonus income at a flat rate using this approach. The rate is typically 25%, but it can vary based on the bonus amount. This means that if you receive a bonus of $1,000, you’re on the hook for $250 in federal taxes on that bonus income, which is 25% of it. In essence, this bonus amount is singled out and taxed separately compared to other income that a taxpayer brings in within a given taxable year, such as a traditional salary from a W-2 job. Many employers prefer utilizing the percentage method because it is simple and not as time-consuming.

The Aggregate Method: The aggregate method is used if an employer adds the amount of a bonus payment to the most recent paycheck of an employee. The employer then determines the normal tax withholding based on current IRS income tax rates to determine the sum of both amounts, subtracts what was already withheld from an employee’s last paycheck, and then withholds the rest from the bonus amount. One drawback to this method is that rather than using a flat tax rate like with the percentage method, you will potentially be on the hook for a higher income tax rate on the combined total of your regular income along with the bonus amount.

Keep in mind that Social Security and Medicare taxes along with state and local income taxes must generally be applied to bonuses and other forms of supplemental wages as well. This means that although the 25% flat rate via the percentage method seems cut and dry, it can become a bit more complex when withholding these additional taxes.

In addition, bonuses in excess of $1 million, which are certainly more uncommon and may be handed out only in the upper ranges of the corporate world, are often taxed at a higher rate. In some cases, the amount in excess of $1 million is taxed at a higher rate compared to the tax rate of the actual $1-million amount. For example, a bonus of $1.5 million may require two separate tax approaches – a higher tax rate on the $500,000 (considered the excess amount) and the regular $1 million taxed at a lower rate.

Holiday bonuses or extra monetary awards for performance achievements are certainly beneficial and more meaningful than a simple pat on the back. However, as with almost any types of income, Uncle Sam is always accounting for taxes regardless of what the money goes toward.

For all of your tax and accounting needs, turn to 1-800Accountant today. Learn more by calling 1-888-749-0117 or by visiting www.1-800Accountant.

Photo credit: The image of the tax return is used with permission via the Creative Commons license through Flickr.

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