Why your bonus could be taxed higher in 2018

You’re eyeing your paycheck with a serious eye. Things are up and looking at the company, and your team is the driving force behind it. The year is ending, and it’s the season for bonuses, and you expect a hefty sum for that dream vacation or a summer cabin or a shiny car. Hold your horses! The new bonus tax rate might eat up the extra money.

How is my salary taxed

Your income tax is calculated on your form 1040, 1040EZ, or 1040A.

All forms of salaries are categorized, and you are taxed according to the income bracket you fall under. The U.S. government has a progressive income tax system, meaning you are taxed more if you are earning more. It is calculated based on the information from the W-4 form that employees submit to their employers and this amount is withheld during payout.

It’s necessary to review your W-4 form before the tax deadline to know if the income tax withheld is accurate. If not enough tax is withheld you will owe the government money and if too much is withheld, then you’ll be eligible for refunds.

Also, it’s important to remember that the IRS takes inflation into account yearly, so you better check the updated tax brackets when you’re doing your tax preparation.

Check the table below to see the federal income tax bracket for the April 2019 deadline:

This progressive federal tax system doesn’t necessarily mean that those earning more than $500,000 (for single filers) or $600,000 (for married filers) will have their entire income taxable by 37%.

Income that falls within the bracket is taxed at 35%, and only the amounts more than the $500,000 or $600,000 threshold are taxed at 37%.

Aside from federal tax, some States also have their income tax system. While some States have a flat tax rate, such as Arizona at 3.07%, other States don’t have income tax on all earned incomes at all.

However, your regular salary isn’t the only form of income you can get within the tax year. Other forms of compensation, such as bonuses, can also be rewarded by offices and companies.

What is considered a bonus?

“Bonuses” are additional compensation given as performance-related incentives to employees. There are several forms of reward schemes in each company, but the most popular form is still a bonus. Bonuses can also come in non-cash forms, such as vouchers or gift items. They can also either be discretionary or non-discretionary.

Discretionary Bonuses

Discretionary bonuses are not mandatory compensation given to the employees. These are not stipulated in the employment contract or agreement. The value is also flexible, as the rewarding of the bonus is triggered by good performance or achievement.

Non-discretionary Bonuses

Non-discretionary bonuses, on the other hand, are legal obligations of employers that may or may not be written in the contract or agreement. Employees must meet defined criteria to qualify for the bonus. This means that employees know what and how much to expect depending on their performance.

Other Bonuses

There are individual bonuses, team bonuses, and company-wide. The first 2 can be discretionary or non-discretionary, while the last is usually a discretionary bonus depending on how well the company’s annual performance is.  

How are bonuses taxed?

They are considered supplemental wages, and as such, taxes for this are considered separate from regular income tax withheld during payout. There are 2 ways in which your tax bonuses are deducted: through the percentage method or the aggregate method.


Percentage method

This method is straightforward and simpler than the aggregate method.

If you receive your bonus as a separate paycheck from your usual income, then the percentage method can be used to calculate your bonus tax.

Tax bonuses are treated differently from your usual income tax withheld during payout. This means that the tax for your income and the tax for your bonus are computed separately.

The previous 25% flat-rate for taxing bonuses has been reduced to 22% this 2018 courtesy of the new provisions within the Tax Cuts and Jobs Act. You get to take a home a little bit more with this new tax rate.

Reduced Tax Rate

So let’s say last year you were rewarded with a $1,000 bonus and you are to receive the same amount this year. Last year, your take-home was $750, with the $250 deduction withheld as your bonus tax. This year for that same bonus, you get to take home $780.

The new 22% rate is uniform across all brackets, but high-earners who get more than $1,000,000 in bonuses get relatively larger portions of deductions. For typical American commoners, it’s easy to envy their six-figure bonuses- that is, until you figure out how much is cut and deducted.

Bigger bonus, bigger taxes

They still get taxed the standard rate of 22%, but only for the amount of $1,000,000 or below. Let’s concretize that: That’s an automatic $220,000 tax cut. And for any amount over the $1,000,000 threshold, it is then taxed at a whopping 39.6%.

Let’s look at the sample calculation below

Say you’re expecting a $1,500,000 bonus at the end of this year:

$1,000,000   x 22% (standard bonus tax rate)   = $220,000

  • This is the bonus tax from your first million

$1,500,000   – $1,000,000   = $500,000 (additional taxable bonus)  x  22% (tax rate for bonuses in excess of $1,000,000)   = $184,5000

  • This is the bonus tax from the amounts exceeding your first million:

$ 220,000   + $184,500  =  $404,500

  • This is the total tax withheld from the two separate tax rates applicable to your $1.5m bonus

So from the $1,500,000 bonus endorsed, you’re going to get only $1,095,000. Fine, let’s admit. That’s still way more than what others earn in a year, and it’s just an added compensation for the top-earners. But the percentage that gets deducted from their bonus is still huge money.


Aggregate method

The other method is the aggregate method. As the name suggests, your income and bonus taxes are computed altogether from the same aggregate amount. If you receive your bonus together with your regular paycheck, then this will be treated as “standard wage” rather than “supplemental wage”. This means it will get taxed the same way your usual income would, instead of following the flat rate of 22% for the bonus.

Say you’re earning $7,000. Looking back at the progressive income tax bracket tables, you would fall in the 10% tax category. If you receive a bonus, say $1,000, your taxable income would then be $8,000.

This should be your income tax computation for a monthly $7,000 salary:

$7,000   x 10% (income tax rate)   = $700

  • This is the usual withheld tax from your paycheck. Your take-home pay is $6,300.

To compute your bonus tax, the withheld income tax from your regular pay will be deducted from the total amount of the paycheck you will receive that includes the bonus. The computation is as follows:

$6,300 (regular take-home pay)   + $1,000 (bonus) x 10% (income tax rate)   = $730.

  • This is the withheld tax for the month that you receive your bonus.

The difference between percentage and aggregate

To see the difference between the amounts of tax and the actual take-home pay, consider the other method.

If you use the percentage method for your bonus tax, the computation for a $1,000 bonus would be:

$7,000   x 10% (income tax rate)   = $700

  • This is the withheld tax from your regular income.

$1,000   x 22% (standard bonus tax rate)   = $220

  • This is the deducted tax from your bonus.

Your take-home pay using the percentage method would be $7,080, including your regular income and bonus.

On the other hand, your take-home pay from the combined check (income plus bonus) using the aggregate method would be $6,570. So for those at the lower brackets, the percentage method is favorable.

Tax Brackets Matter

Technically, your tax rate for your bonus using the aggregate method is lower at 10%, but the computation is based on the sum of the take-home pay and the bonus, making the deduction larger.

Let’s say you’re at the 35% income tax bracket. Instead of the 22% flat bonus tax rate, your bonus will be subject to 35% tax as well.

Don’t worry, it doesn’t automatically mean you will be paying more for your bonus tax. When you actually file your taxes, your actual overall tax rate may be lower than the withheld taxes. You’re likely to get refunds if too much tax is withheld from your income.

Other Tax Liabilities

You might also have other tax liabilities from your bonus such as the 6.2% Social Security tax and the 1.45% Medicare tax. Nevertheless, a bonus no matter how much the amount is still additional compensation that you can put to good use.

How to make the most of your bonus

Stop counting the many ways you can spend your upcoming bonus. Start thinking of how you can put it into good use before you spend it all on leisure and luxury. Let’s face it, when we anticipate extra money to come, we tend to become careless with our financial decisions.

Since your bonus is something outside of your expected salary, it’s not part of the usual budget you make for all your necessities and personal expenses. FileTaxesOnline recommends that you:

1. Pay off debt

If you have a credit card debt (or any accumulated debt for that matter), that should be the first thing that comes to mind when you are thinking of financial allotments.

If you haven’t realized it yet, but your credit score matters when you are trying to get financial assistance in the form of loans for example. It takes time to improve your credit score, so don’t let it go down the rabbit hole.

Getting extra cash means you can pay any amount to lower your liabilities. It doesn’t have to be your entire bonus check. Do yourself a favor and take care of your financial responsibilities first. Then you can spend the remaining amount however you want.

2. Make the necessary purchases or repairs

Another responsible decision you can make is to put the necessary expenses first. If you’ve been holding off that major household repair because you can’t fit that in your monthly budget, then use that additional compensation you are getting.  

3. Invest the money

There are many ways to spend your money, and one of the best ways is to invest it. You’re not even “spending” it. Basically, you’re just putting it away for a while to let it grow for future use.

There are many forms of investment, but not all purchases are investments. If you think that buying that expensive item is a good investment, you’re mistaken. Anything that depreciates in value as time goes by is NOT an investment.

You can put that bonus to your retirement plan, to your children’s educational plan, or your emergency funds. You can even tuck it away to save up for a big purchase in the future, such as a second home or a car.

4. Donate to charity

If you’re feeling generous, you can donate a portion of your bonus to charity. It’s a win-win situation for you and the foundation because your donations can give you tax breaks. You have to itemize this deduction on Schedule A of your form 1040.  

5. Enjoy it!

You deserve to enjoy your hard-earned bonus. If you are not behind on debts, don’t have any upcoming bills or commitments that will cost a lot, then maybe you can spoil yourself or your loved ones.