It’s the holiday season, which means employees in many companies may be receiving a holiday bonus! So, what are the tax implications? Per Internal Revenue Service (IRS) guidelines, all bonuses issued via check/direct deposit or in the form of gift card (cash equivalent) are considered supplemental taxable wages. Additionally, holiday bonuses are considered discretionary, and therefore do not need to be included in overtime pay calculations for non-exempt employees.
For bonuses under $1 million, there are two methods used to calculate the taxes:
The Percentage Method
The IRS specifies a flat supplemental rate of 25%. This method taxes the entire bonus at a uniform rate and is easy to calculate, plus normally results in a higher net amount than the aggregate method described below. Via the percentage method, if an employee is issued a $5,000 bonus, $1,250 goes to taxes, netting the employee $3,750.
The Aggregate Method
Here, instead of separating the normal pay from the bonus amount, the employer combines the wages of the last paycheck and the bonus. The withholding amount is based on IRS withholding tables for the sum of both amounts, and what was already withheld from the last paycheck is subtracted, with the rest withheld from the bonus amount. Instead of taxes being withheld at a flat 25%, taxes are withheld on the combined amount of the normal pay and the bonus, which normally results is a higher tax obligation than if the percentage method was used.
Note that prior to receiving large bonuses, employees may wish to change their withholding allowances for that one check/deposit only, so as to net more of the bonus. This will require the submission of two W-4’s: one to change the withholding for the bonus check/deposit, and a second to return to their standard withholding amount. Employers must allow employees to change their W-4 forms as often as they wish.
A parting thought: if you have told an employee that he/she will be receiving a $5,000 bonus, for example, please be clear whether $5,000 is the gross (pre-tax) or net (take home) amount that will be received, remembering that the employer has the option to “gross up” a bonus. This means that the employee may be issued more than $5,000 to allow for withholding. Using the same example, if an employer communicates that an employee will take home a $5,000 bonus, by including the estimated taxes in the amount issued (for example: approximately $6,670), the employee will net the full $5,000.
The above is meant for informational purposes; you are encouraged to consult with your tax professional should this be an area of interest for you.