A bonus from work can be a pleasant surprise. However, the amount of taxes withdrawn from your bonus may be a not-so-nice surprise. Whether you are using your bonus for a fun vacation, a lavish Christmas, or to increase your retirement contributions, know that you will receive significantly less of your bonus than you expect thanks to taxes. However, you can utilize a bonus tax strategy to minimize the damage.
Why Are Bonuses Taxed So High?
Because bonuses are considered supplemental income, they are taxed differently than your regular income. Your employer can choose between two taxation methods:
Using the percentage method, your employer will withhold a flat 22% for taxes on the first one million. If your bonus is over one million, your employer will withhold 22% for the first million and 37% for the amount over one million.
If your employer is including your bonus as part of your regular paycheck, they’ll likely use the aggregate method. Under this method, your employer will withhold whatever you usually have withheld from your regular paycheck.
Unfortunately, neither of these methods is exact. For example, if your employer uses the percentage method, you may have too much tax withheld if you’re in a lower tax bracket or not enough if you’re in a higher tax bracket.
The aggregate method may result in too much tax being withheld, which means you won’t get all of your money immediately but will need to wait for a tax refund after you file your taxes.
You May Pay More Than Taxes
You may have more than federal and state taxes withheld. In addition, you might also have to pay a 6.2 percent Social Security tax and 1.45 percent Medicare tax.
Bonus Tax Strategy
Thankfully, you can utilize these strategies to minimize the impact of the taxes pulled from your bonus.
Invest in Your 401(k), HSA, or Traditional IRA
You can reduce your tax liability by investing the bonus in your 401(k), HSA, or traditional IRA because that contribution is made with pretax dollars, which can help lower your taxable income, and, therefore, your overall tax obligation.
Defer the Bonus
If your company plans to pay the bonus in December and it will push you into a new tax bracket, ask to defer the bonus until next year. This is helpful if you know you’ll earn less next year, especially if you plan to retire.
Donate to Charity
Consider donating some of the bonus to charity. However, this strategy will only help if you itemize your return; if you take a standard deduction, a donation will not help lower your tax burden at the end of the year.
Bonuses can be pleasant surprises, but taxes are not. To minimize the damage, use these bonus tax strategy tips to reduce your taxable income and tax responsibility.
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Melissa is a writer and virtual assistant. She earned her Master’s from Southern Illinois University, and her Bachelor’s in English from the University of Michigan. When she’s not working, you can find her homeschooling her kids, reading a good book, or cooking. She resides in Arizona where she dislikes the summer heat but loves the natural beauty of the area.