Table of contents
When you want to reward your team for a job well done, there’s little employees appreciate more than a bonus. While employee bonuses may be an effective way to build employee loyalty and boost morale, it’s important to understand the unique tax rules that come with them.
So, how are bonuses taxed? Continue reading to learn about the bonus tax rate and how it applies to your business and your valued team.
How are bonuses taxed by the IRS?
At tax filing time, the IRS treats bonus income just like any other income. But for tax withholding, which is the amount retained by employers for taxes when the bonus is paid, the rules work differently. That means both employees and employers should be prepared for a different process for bonuses than what’s typically experienced with regular payroll.
Bonuses are considered supplemental wages by the IRS. Commissions, overtime pay, accumulated sick leave, severance, back pay, reported tips, and other irregular payouts may also be considered supplemental wages for tax withholding.
When an employee receives a raise, where a pay increase is ongoing, it’s treated differently than a bonus. In the next section, we’ll look at the two options you have to handle tax withholding for bonuses. These are known as the flat percentage method and the aggregate method.
The IRS rules on the two withholding options
The rules for federal tax withholding give employers two options when paying bonuses to employees. The first factor to consider is how you pay out the bonus, as the chosen method determines how to calculate withholding. Will the bonus be on a separate payroll or be included in an existing pay cycle?
A dedicated payroll provider can help you run a bonus payroll and automatically withhold the correct amount of taxes.
The first option, referred to as the flat percentage method, is to split the bonus from regular wages and run the bonus on a separate payroll. The second option, known as the aggregate method, involves combining regular pay and any bonuses on the same payroll. Note, this method generally means the total amount of federal tax withheld is at a higher rate than a normal payroll since it combines regular pay and bonus amounts and applies taxes to the sum total of the two.
Flat percentage method
The easiest method to use is the flat percentage method. As of 2024, bonuses are taxed at a flat withholding bonus tax rate of 22% for taxes up to $1 million. If the bonus exceeds that threshold, then the remainder of the bonus is taxed at 37%.
In practice, a bonus of $1 million or less means:
- Take the total bonus amount and multiply it by 0.22
- Take that result and subtract it from the total bonus amount
- Note: Other factors may impact the total cash amount received by an employee, such as Social Security, Medicare, state and local taxes, and potentially some benefit withholdings such as 401K.
Even though it may seem like a simple calculation, taxes can carry individual considerations for employees. Make sure to provide personnel with explanations from the IRS on why their bonus is being taxed in this way, and, if there are any questions, consult a tax professional.
Aggregate method
With the more complex aggregate method, supplemental wages and regular wages are both considered when calculating withholdings. The bonus is not separated from the regular payroll cycle but is instead added to the existing payroll. The bonus withholding takes the “aggregate” total of the bonus given to an employee and combines it with the employee’s regular pay to arrive at the correct withholding amount. Employee withholding, Social Security, and Medicare will be based on the sum total of the bonus and the regular payroll amounts. Aggregating total pay can move the employee wages into a different tax bracket, resulting in a much different withholding than an employee may have been expecting on that payroll.
Factors that can impact the results of the aggregate method include:
- The amount of gross income earned, so regular wages plus supplemental wages (such as a bonus)
- Filing status of the employee
- Number of withholding allowances claimed
- Additional withholding (if an employee opted for an additional amount to be withheld from each paycheck)
To calculate the withholding amount, business owners must:
- Add supplemental wages (such as a bonus) to regular wages
- Figure the income tax withholding as if the total of the regular wages and supplemental wages is a single payment utilizing the IRS wage brackets.
Taxes can be a complicated and stressful matter for employees. Support them by providing resources to better understand tax withholding, reviewing their W4 regularly (especially after major life events such as marriage or a newborn), and highlighting the value of working with a tax professional.
How the IRS taxes employees
Are bonuses taxed? The answer is yes. When it comes time to file an annual tax return, employee bonuses are taxed in these three ways:
Federal taxes: Federal taxes are calculated based on total annual income and are usually due in April. Here are links to the 2023 and 2024 tax brackets.
Federal FICA taxes: In addition to regular income taxes, bonus pay is subject to Social Security and Medicare tax. Often referred to as payroll tax, you may see it listed as FICA on a pay stub, which is short for the Federal Insurance Contributions Act. Employees who earn over $200,000 are subject to additional Medicare taxes of 0.9%.
State taxes: Unless employees live and work in a state with no income tax, they should count on paying state taxes as well.
How the IRS taxes employers
Federal tax withholding for bonus pay may work differently than regular pay, but the total tax due on the employer side is the same, regardless of how the employee is paid.
Employer payroll taxes on bonuses make up the rest of the pot for Social Security and Medicare. Employers match the same 6.2% tax for Social Security and 1.45% for Medicare that employees pay, up to the annual income limit.
For 2024, the maximum earnings for the Social Security payroll tax calculation is $168,600. For any income above that threshold, Social Security is not withheld. There is no corresponding wage limit for the Medicare portion of the FICA tax.
Deducting bonuses as a business expense
All payments made to employees are tax-deductible business expenses. Payroll taxes are also deductible, which lowers the total business income for tax purposes. If you use Square Payroll, you can access your tax forms directly in your Dashboard.
Don’t let bonus taxation overwhelm your business
Bonus season can be a meaningful time since it allows you to appreciate people for all their hard work. Pay attention to the tax impact, plan ahead, and don’t let the math around how bonuses are taxed add too much stress to your plate.
