How Are Bonuses Taxed? A Small Business Guide to Tax Rules

That end-of-year bonus you're planning for your team comes with a bit of extra work for you as an employer. While you and your employees may want to regard bonuses as additional income, the Internal Revenue Service (IRS) classifies them as supplemental wages. That means each bonus is subject to specific withholding rules that are different from those for regular payroll.

Understanding how to tax bonus payments helps you avoid filing issues. It can also make it easier for you to communicate with employees, who might wonder why their bonus check seems smaller than expected. Here's what you need to know.

How Bonus is Taxed: Federal Withholdings

The IRS gives you two options for withholding federal income tax on bonuses: the percentage method and the aggregate method. Your choice affects how much tax you need to withhold from each bonus payment. It's important to remember that your employees' final tax liability will only be determined when they file their annual returns. Here's more information on each method:

The Percentage Method

When you pay bonuses separately from regular wages or clearly identify the bonus amount, you can use the percentage method. It means that you're withholding federal income tax at a flat 22% rate for supplemental wages up to $1 million per employee per year. Here are the key details:

• Simple Calculation: Apply 22% to the gross bonus amount.

• Consistent Withholding: The same rate applies regardless of the employee's regular tax bracket.

• High Earner Consideration: If the bonuses are pushing total supplemental wages above the $1 million mark, you need to tax them at 37% for amounts over that threshold.

• Employee Communication: Clarify that the 22% is only the withholding rate and that the actual tax rate depends on their total annual income.

The Aggregate Method

If you combine bonuses with regular wages into a single payment without specifying separate amounts, you need to use the aggregate method. This method usually results in higher withholding amounts because the payroll system treats the larger payment as the employee's regular earnings for that pay period. Here are the key details:

• Combined Payments: You include the bonus with the regular paycheck without itemization.

• Higher Withholding: You may withhold more tax due to progressive tax brackets.

• W-4 Dependent: You use the employee's regular withholding information.

• Employer Choice: You can choose this method even when you're paying bonuses separately.

Beyond Federal Taxes: FICA, State, and Local Considerations

Federal income tax withholding isn't the only tax that applies to bonus payments. Several other taxes come into play. Here are some examples:

FICA Taxes on Bonuses

All bonuses count as wages for Social Security and Medicare purposes. That means you're withholding the Social Security tax of 6.2% on the employee's contribution (plus a 6.2% employer match) up to the annual wage base. You also need to withhold the 1.45% employee contribution (plus a 1.45% employer match) on all wages for the Medicare tax. If the wages exceed $200,000, you also need to withhold an additional 0.9% employee-only Medicare tax.

When processing year-end bonuses, you need to verify whether your employees have already hit the Social Security wage base. Any amounts over the limit are not subject to Social Security tax but still incur Medicare taxes.

State and Local Tax Treatment

Most states treat bonuses as regular wages for tax purposes, though specific withholding methods vary. Many states have a flat percentage rate. Some states mandate particular rates for supplemental wages. Other states apply standard income tax withholding.

If you have employees in different states, the question of 'how are bonuses taxed' can become even more complex. Remote employees may trigger withholding requirements in multiple jurisdictions. Check with your state revenue department or leverage your compliance support to ensure accurate withholding on bonus payments.

Overtime Implications: When Bonuses Increase Pay

Suppose you have non-exempt employees who are entitled to overtime pay for hours worked over 40 in a workweek. In that case, how to tax bonus payments is based on how you classify them: discretionary or non-discretionary. You need to include non-discretionary bonuses in your overtime calculations for non-exempt employees.

This distinction is essential: misclassifying non-discretionary bonuses as discretionary creates significant wage-and-hour liability. When designing your variable pay programs, you should clearly document your bonus terms to support your classification. Here's a side-by-side comparison:

To calculate the overtime impact of your bonus payments, you need to spread non-discretionary bonuses across the weeks worked. Add the allocated bonus to the base pay before calculating overtime. Pay the additional overtime or issue retroactive payments, if needed. Keep all your documentation showing the bonus criteria and the calculations you used to determine the bonus.

Common Bonus Tax Mistakes and How to Avoid Them

As with any complex tax calculations and reporting requirements, the process of taxing bonuses can be tricky. These missteps can easily compound when you're managing end-of-year bonus considerations across multiple locations or remote teams. Here are the most common errors and their solutions:

Mistake 1: Using the Wrong Withholding Method

In this common situation, you may be applying the aggregate method to separately paid bonuses, resulting in an incorrect withholding amount. The solution? Configure your payroll system to recognize bonus payments and use the 22% withholding rate (percentage method).

Mistake 2: Forgetting the Additional Medicare Tax

If your employee earns more than $200,000, you need to withhold an additional 0.9% Medicare tax. Without automated methods, it's easy to miss it. The solution? Track your employees' year-to-date wages and automatically trigger additional withholding when wages reach $200,000.

Mistake 3: Incorrect W-2 Reporting

Some companies mistakenly include employee bonuses on 1099 forms (which you use for independent contractors). The solution? Include all your employee bonuses in W-2 wages and report them on a Form W-2. If you want to give an independent contractor a bonus, you'll need to fill out a Form 1099-NEC.

Mistake 4: Missing State Tax Requirements

Another common misstep is applying federal rules to state withholding amounts. The solution? Research each state's supplemental wage requirements and adhere to them, or seek professional help.

Streamlining Bonus Administration with Justworks

Managing the taxation of bonuses across jurisdictions requires attention to detail. Small businesses juggling growth with compliance requirements need systems that can handle the increasing complexity. Our Professional Employer Organization, PEO, simplifies bonus administration through automated tax calculations, multi-state compliance management, expert support, and integrated payroll processing. Get started with Justworks today.