It’s exciting to get a bonus at work. It’s less exciting to see how much you owe in income taxes on that windfall.
While you can’t necessarily avoid taxes on a bonus check, it's important to understand how your bonus will be taxed so there aren’t any surprises at tax time. Learn more about what to expect when you get that highly anticipated bonus check so you can keep more of your money and build wealth.
How are bonuses taxed?
If your bonus is distributed as a separate payment from your regular paycheck, it’s considered supplemental wages and will be taxed at a flat rate of 22%. This is known as the percentage method for calculating bonus taxes. State taxes vary, so it's best to check the rules for your state.
If the bonus is distributed as part of a regular paycheck, it will be taxed like regular income. That means it’s based on your normal tax withholding elections for your paycheck. This is also known as the aggregate method for calculating bonus taxes.
Which of these options is best depends on your tax bracket. If you’re in a higher tax bracket than 22%, then the percentage method may be best for you. If your tax bracket is lower, the aggregate method may be best. Ultimately, your employer will decide which method they’ll use, but let your employer know if you have a preference.
If your bonuses are paid separately from your regular paycheck, and the bonus amounts exceed $1 million in a calendar year, the amount of your bonus that exceeds $1 million will be taxed at a 37% flat rate. The first $1 million will be taxed at 22%.
If too much in taxes is withheld from your bonus pay, you may get a tax refund depending on your overall tax situation.
How are regular paychecks taxed?
Taxes are withheld from your regular pay based on information you provide on your Form W-4, including your marital status and the number of dependents. You can also request that an additional amount be withheld for federal or state purposes, which can help you when it’s time to file taxes if you tend to owe money.
Your employer will also withhold money to cover Medicare and Social Security taxes, which are a combined 7.65% of gross wages. Employers also withhold an additional 0.9% of Medicare tax for employees who make more than $200,000 in a calendar year. The additional tax starts the pay period that wages exceed $200,000 and runs through the end of the calendar year.
There is also an upper earnings limit each year above which no Social Security taxes are withheld. According to Social Security, the upper limit was $147,000 for 2022 and is $160,200 in 2023.
5 ways to minimize taxes on your bonus
We aren’t trying to tell you how to avoid taxes on your bonus check, but these suggestions can help you manage the amount of taxes associated with your bonus so you can keep more of your money. Also, it’s important to focus on your overall income tax situation, not just how much tax is withheld on the bonus check.
1. Utilize deductions
There are a number of potential deductions that you may be able to use as long as you are able to itemize deductions. These could include:
- Charitable contributions: Depending upon the size of the bonus, you might want to make the equivalent of several years’ worth of charitable donations this year to take full advantage of this deduction.
- Medical expenses: If you have higher than normal medical expenses, they can be itemized if they are above 7.5% of your adjusted gross income.
- Mortgage interest: You can deduct mortgage interest on up to $750,000 of mortgage debt on a primary or second home.
Note that it may not make sense to itemize, as the standard deduction is relatively high ($25,900 for married couples filing jointly and $12,950 for single filers for the 2022 tax year, and $27,700 for married couples filing jointly and $13,850 for single filers for the 2023 tax year). If your itemized deductions add up to less than the standard deduction, it may be best to take the standard deduction.
2. Increase 401(k) contributions
This is a great use for some or all of your bonus money and can potentially mitigate the tax impact of this extra income. The best method and timing for doing this will vary based on your personal circumstances and the timing of the bonus payment.
If you are not maxing out your contributions to your company’s 401(k) plan or another retirement account, you should consider using some or all of the bonus to increase your contributions to the plan. The 2022 401(k) contribution limit is $20,500, with an additional $6,500 catch-up contribution for those who are 50 or older. The total amount you can contribute in 2023 is $22,500, with a catch-up contribution limit of $7,500 for those who are 50 and older.
Besides the tax benefits of a pre-tax contribution to a traditional 401(k) account, this is a great way to boost your savings for retirement.
You will want to check with your payroll or benefits department about the logistics of doing this. Some companies might allow you to make a larger contribution directly from the bonus payment. If this can be done, figure out how much you can contribute in addition to what you will have contributed by the end of the year with your regular payroll deductions.
As an alternative, you can consider bumping up your contributions each payroll period to boost your annual contributions and use the money from your bonus check to offset this amount. An even better alternative is to use the money to bump up both your contributions and your spouse’s.
If you are already contributing the max to your 401(k) and are married, you could use some of the money to bump up your spouse’s contribution to their 401(k). You will still reap the benefits of added pre-tax contributions and increased retirement savings. Again, you will need to “front” the money via your spouse’s added payroll deductions and reimburse yourselves once the bonus is received.
3. Increase traditional IRA contributions
Another way to potentially lower your taxable income from a bonus check is to contribute to a traditional IRA account. You can deduct those contributions from your pre-tax income, which lowers the amount of income you’re taxed on and helps balance out the tax hit from your bonus check.
If you’re covered by a retirement plan at work, like a 401(k) plan, you can only deduct your contributions if your income is below certain limits. The limit for 2022 is $78,000 for single filers and $129,000 for married couples filing jointly. The limit for 2023 is $83,000 for single taxpayers and $136,000 for those who are married and file jointly.
If you’re not covered by a retirement plan but your spouse is, the income limit for deducting contributions is $214,000 for 2022 and $228,000 for 2023.
4. Increase HSA contributions
If you have a designated high deductible health plan (HDHP) as your health insurance, you’re eligible to contribute to a health savings account (HSA) tax-free. For 2022, the contribution limit for someone with individual coverage is $3,650, and up to $7,300 for family coverage. For 2023, you can contribute up to $3,850 as an individual and up to $7,750 for family coverage. There is an additional $1,000 contribution available in both tax years for those 55 or over.
The beauty of an HSA is that the contributions are pre-tax, and the money can be carried over to subsequent years or even to retirement if not needed for medical expenses. Bumping up your HSA contributions can be a good way to use some of the bonus money and offset some of the taxes as well.
5. Have your bonus combined with your regular paycheck
Some companies pay bonuses as part of a regular payroll check, while others may do this if you ask. The advantage here is that the bonus will be taxed based on your normal withholding and not subject to the 22% mandated rate for supplemental income. Additionally, 401(k) contributions will be made based on your normal deferral percentage.
Can you give an employee a bonus without taxes?
You can’t give an employee a bonus without taxes. The IRS mandates that taxes be withheld from a bonus payment at either their regular federal withholding rate if it’s paid with their regular wages or at the 22% supplemental rate.
What is the tax rate on bonuses?
The tax rate on bonuses is 22% for federal taxes if the bonus check is made as a separate payment from your regular paycheck. If the bonus is included as part of your regular paycheck, then the withholding in place for your regular salary would apply.
Can you claim a bonus as a tax deduction?
You can’t claim a bonus as a tax deduction. The employer paying the bonus can claim it as a payroll expense just like other compensation paid to employees.
Receiving a bonus is a great thing. Having to pay federal income tax (along with state and local taxes) on the bonus isn’t as great, but it’s a requirement. Managing your potential tax bill is important, and there are a number of steps to consider.
It’s best to focus on your overall tax situation when deciding how to handle your bonus tax situation. Check out our article on the best tax software to assist you if you file your tax return on your own or seek out the assistance of a tax advisor.