Giving bonuses to workers is one method to thank them for a job well done. Although incentives are a terrific way to show your gratitude for your staff, they do have some unique tax requirements. It’s crucial to comprehend the correct tax computations in order to ensure that you’re withholding the appropriate amounts from bonuses since they are taxed differently than normal income.
Are employee bonuses taxable?
Employee bonuses are regarded as taxable income, yes. Employee bonuses are seen by federal and state tax authorities as an additional source of employee income, and as with the ordinary salary you pay your workers, any incentives you provide them are subject to taxation. However, since the IRS considers bonuses to be additional compensation, bonuses are taxed differently than ordinary pay.
What is the bonus tax rate?
The rate of bonus tax is 22%. There is a 22% tax rate on the first million dollars and a 37% tax charge on everything beyond that if you give an employee a bonus of more than $1 million.
These numbers only apply to the federal bonus tax rate; you must withhold extra federal and state taxes on bonuses.
How do employee bonus taxes work?
Federal bonus taxes, extra federal taxes, and state taxes are the three kinds of taxes a business is required to pay on employee bonuses.
Federal bonus taxes
The rate of the federal bonus tax is 22%, as was already mentioned. Nevertheless, the way that federal bonus taxes operate varies depending on when bonuses are offered to workers. You deduct taxes at the federal flat rate of 22% when you give bonuses to your workers in payments that are totally different from their regular paychecks. The % technique is what is used in this. The aggregate technique is used if you add your workers’ bonuses to their subsequent, regularly scheduled payment. Below, we’ll go into greater detail about each of these approaches.
Additional federal taxes
Bonuses are subject to Social Security and Medicare (FICA) taxes in addition to the federal bonus tax. Similar to ordinary salaries, the first $137,700 you pay each of your workers is subject to a 6.2% Social Security tax in 2020. Similarly, the Medicare tax rate for 2020 is 1.45% for all earnings under $200,000, including bonuses, and 2.35% for all salaries beyond $200,000. You may often calculate bonus withholding using the combined Social Security and Medicare tax rate of 6.2% + 1.45% = 7.65%.
State bonus taxes
You should determine the state bonus tax after determining how much federal bonus tax and FICA tax to deduct from bonuses. Usually, this is the process’s last tax.
The majority of states, though not all, tax bonuses. Even some states have distinct bonus tax rates for certain bonus kinds. The state supplementary pay tax rate in California, for instance, is 6.60% and rises to 10.23% on bonuses and stock options. Before determining how much state bonus tax you must withhold in Maryland, you must also multiply the 5.75% state bonus tax rate by your local tax rate. For information on state bonus taxes, see a list to estimate your withholding obligations.
How to calculate bonus taxes
Now that you are aware of the different bonus taxes you will be required to deduct, you must understand how to do the correct calculations. After all, if you pay your workers bonuses as separate paychecks as opposed to additions to regularly scheduled paychecks, you must compute bonus tax withholding in a different way. You’ll apply the percentage approach in the first situation, and the aggregate method in the second.
Tax liabilities and the percentage method
Say, for instance, that your business has its headquarters in a Colorado city without a bonus tax and that you give an employee a $1,000 bonus through check or direct deposit in addition to their normal salary. You use the percentage technique to determine the federal bonus tax in this situation.
Let’s start with the federal bonus tax of 22%:
Federal bonus taxes on $1,000 divided by 0.22 equal $220.
Calculate the FICA tax withholding after that:
FICA taxes on $1,000 divided by 0.765 equal $76.50.
Lastly, use Colorado’s state bonus tax rate of 4.63% to get the state bonus tax withholding:
Colorado state bonus taxes on $1,000 multiplied by 0.0463 equal $46.30.
Here is what you get when you sum together all of the bonus tax liabilities:
Bonus taxes were $220 + $76.50 + $46.30 for a total of $342.80.
As a result, instead of giving your employee $1,000 as a bonus, you will give them $657.20 ($1,000 – $342.80).
Tax liabilities and the aggregate method
Let’s assume once again that your business is located in a region of Colorado without a local bonus tax. You use the aggregate technique to determine your federal bonus tax if you give the same $1,000 bonus to an employee as part of a regular paycheck rather than as a totally separate payment.
The 22% federal bonus tax rate never applies under the aggregate approach. Instead, you determine the amount of tax deducted from the bonus you’re paying using regular federal income tax rules. Giving a $1,000 bonus to a worker whose regular monthly income is $6,500 amounts to effectively paying the worker $7,500 for the month.
As a result, the employee’s monthly effective annual wage is different from the normal $6,500 x 12 = $78,000. Rather, it comes to $7,500 x 12 = $90,000. The employee’s $90,000 effective annual salary with the bonus falls into a higher federal income tax bracket for which taxes are assessed at a 24% rate, as opposed to their standard $78,000 annual income, which translates to a federal income tax rate of 22% (assuming the employee is a single filer who isn’t the head of a household). You will deduct taxes from the bonus you are giving at this rate.
As a result, unlike in the preceding case, your federal bonus tax withholding is not $220. Here’s how to figure it out:
$1,000 x 0.0024 = $224
The state bonus tax and FICA tax computations are unchanged.
Be aware that compared to the percentage technique, the aggregate method needed far more effort to account for a $4 rise in federal bonus tax. Many businesses use the percentage technique since the aggregate method may lead to larger bonus tax withholding and is more time-consuming to compute.