For many workers, putting in long day is more than a matter of getting work done and ensuring job security. Some employers offer bonus pay based on employee performance that can significantly boost annual income. If you are lucky enough to score a bonus, don't start planning your next vacation or test-drive a new car before you actually get your money. The federal government has special tax laws related to bonus income that can take a big bite out of your bonus and affect the amount that you actually receive.
Bonus Pay Basics
Bonus pay is a form of compensation for work that is subject to federal income taxes just like normal salaries and wages. The IRS considered bonus pay "supplemental income" along with commissions, overtime pay, prizes, awards, back pay and accumulated sick leave. All these types of income are subject to the same special tax withholding rules. Bonus pay is also subject Social Security tax and Medicare tax.
In some companies, bonuses and other types of supplemental income like commissions are built into regular paychecks. For example, sales professionals might have a bonus or commission scheme where strong performance is automatically factored into pay. The IRS says that in situations where supplemental income and regular wages are not divided into two distinct payments, your employer treats the income as normal wages.
Bonuses that are identified as amounts separate from wages are subject to tax withholding at a flat rate of 25 percent. This means that your bonus faces 25 percent tax withholding even if your normal tax rate is less than 25 percent. Alternatively, the IRS says that employers can treat wages and bonus received at the same time as a single income payment for the purposes of calculating tax withholding.
The IRS imposes additional tax rules on workers who receive especially large bonuses. According to the IRS, if the supplemental income given to a worker over the course of a year exceeds $1 million, any amount in excess of $1 million is subject to an automatic withholding rate of 35 percent. The 35 percent rate applies regardless of what the worker claimed on Form W-4. Form W-4 is a tax form that employees fill out when taking new jobs to help employers determine how much tax to withhold from their pay.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.