It’s the time of year when employers are contemplating year-end bonuses for their employees. If you’re planning on giving your employees more than a membership in the jelly-of-the-month club this Christmas, there are some considerations to keep in mind when it comes to how bonuses are taxed.

Bonuses can be taxed differently

The IRS considers bonuses to be “supplemental” wages, which are defined as pretty much any compensation other than regular wages. Supplemental wages can be taxed in combination with regular wages using the Aggregate Method, or separately using the Percentage Method.

Aggregate Method

Using this method, taxes are calculated on the lump sum of both regular wages and the bonus. This can have the effect of increasing the amount of taxes withheld from the paycheck, because it temporarily bumps the employee into a higher bracket of the withholding tables.

Employees tend to be familiar with this tax affect, because they often express surprise at how much tax is withheld from their bonus. In order to counter this effect, the IRS allows another way to taxing bonuses, known as the Percentage Method.

Percentage Method

Under this method, federal income taxes on the bonus are withheld at a flat rate of 22%. Simple as that. This gives employers the option of withholding a predictable amount of taxes, and keeps higher income earners from having a more-than-usual amount of taxes taken out of their check.

Myths to dispel

Myth: Employees get to choose which tax method is used.
Truth: It is the employer’s choice. However, employers can certainly take their employees’ preferences into account.

Myth: Employees can choose how much is withheld from their bonus, or even choose to have nothing withheld.
Truth: The IRS only specifies the Supplemental and Aggregate methods of taxation for bonuses. Customized withholding is not allowed.

Myth: If I pay cash bonuses, I don’t need to worry payroll taxes.
Truth: No way. Any cash or cash-equivalent compensation (think: gifts cards) needs to have the proper payroll taxes applied.

Any questions about bonuses in your company? Feel free to reach out.