'Tis the holiday season, and that means vacation time, holiday parties and, the most loaded perk, holiday bonuses. But before spending your bonus, find out how much you'll really receive after taxes are withheld. While bonuses are separate from your regular pay, the IRS still views this money as income and has special rules regarding withholding taxes on bonuses. Here's everything you need to know about how withholding taxes are calculated on your end of year bonus.
Bonuses Defined
Bonuses are considered "supplemental wages" and according to the IRS, supplemental wages are defined as compensation paid in addition to the employee's regular wages that include but are not limited to things like vacation pay, overtime, moving expenses, severance pay and last but not least, bonuses. If your bonus and regular wages are specified separately and income taxes were withheld from your regular wages in the current or immediately preceding year, there are two methods used to calculate taxes withheld on a bonus, the percentage method and the aggregate method.
Percentage Method - If your employer uses this method, your bonus will be taxed at a flat 25 percent rate. For example, if you receive a $5,000 bonus, $1,250 (25 percent) goes to the IRS. This method is ideal for both the employer and employee, as it is less time consuming to figure out, and may leave you with a larger post-tax bonus amount than the Aggregate Method depending on your tax bracket.
Aggregate Method - If your employer uses the aggregate method, your bonus may be taxed at a higher rate since your withholdings are calculated by combining your bonus with your most recent regular wages for the pay period and using your tax rate based on information provided on your W-4 form.
Tax Tip: Bonuses are included in your total income for the year and your overall tax rate is based on information you provide on your W-4 form. If your bonus puts you in a higher tax bracket this year and you expect to make less next year, see if your employer can defer your bonus to lower your tax bill this year.
Bonus Calculator: Know Exactly What You're Getting
To see how much may be withheld from your bonus this year, check out this bonus calculator.
Reduce Your Current Year Taxes with Your Bonus Money
If you spend your bonus on the right things, you could end up getting a tax savings to help offset the taxes withheld on the bonus income. Here are some tax benefits for using your bonus money:
Retirement Savings - Use your bonus money for additional retirement plan contributions. You could do this through your 401(k) or 403(b) at work. Just make sure you get the money into your account prior to the end of the year. You can contribute up to $17,500 to your 401K ($23,000 if over 50). If you don't have an employer plan, you could make a traditional IRA contribution. With an IRA you have until the date you file your taxes to make the initial contribution, just make sure you specify what tax year it's for.
Green Home Improvements - Residential energy-efficient home improvements may provide you with a tax credit of up to 30 percent of the cost of the improvements. Qualifying improvements include things like solar water heaters and solar panels.
Give it Away - Giving money to a qualifying charitable organization will provide you with a tax deduction as long as you itemize deductions on your return.
Make Pre-Payments - If you have a mortgage, consider making your January mortgage payment in December. This will add to the amount of mortgage interest you paid in the year. Like charitable contributions, mortgage interest is deductible if you itemize. You should also consider making your property tax payments prior to year end, as this will give you another deduction.
Do you have other questions about bonuses? Be sure to visit the TurboTax blog or leave us a comment.