When you are paying employee bonuses, it is important to understand how they should be taxed.
- Employee bonuses are taxable, and the withholdings calculations differ from those used for standard wages.
- The federal bonus tax rate is 22%, and you'll also have to withhold FICA taxes and, sometimes, state bonus taxes from bonuses given to employees.
- Calculations for tax withholding for bonuses paid separately from paychecks differ from calculations for bonuses paid alongside paychecks.
- This article is for employers and payroll specialists who need to withhold taxes on bonuses they give their employees.
One way to recognize employees for a job well done is to reward them with a bonus. But although bonuses are great for employee appreciation, they come with a twist: their own tax rules. Bonuses are taxed differently than regular wages, so it's important to understand the proper tax calculations to make sure you're withholding the right amounts.
Are employee bonuses taxable?
Yes, employee bonuses are considered taxable income. In the eyes of federal and state tax authorities, employee bonuses are another form of employee income, so as with the standard wages you pay your employees, any bonuses you give your employees are taxed. However, bonuses are taxed differently than standard wages, because the IRS classifies bonuses as supplemental wages.
Key takeaway: Employee bonuses are taxable, but the calculations for withholdings differ from those used for standard wages.
What is the bonus tax rate?
The bonus tax rate is 22%. If you pay an employee a bonus of more than $1 million, there is a 22% tax rate on the first million dollars and a 37% tax rate on everything above that.
These figures pertain solely to the federal bonus tax rate; there are additional federal and state taxes you must withhold on bonuses. [If you want to make sure you are withholding the proper taxes from your bonuses, consider using online payroll software. Start with our recommendations for the best online payroll software.]
Key takeaway: The federal bonus tax rate is 22%. However, for bonuses over $1 million, any amount over $1 million is taxed at 37%.
How do employee bonus taxes work?
There are three types of taxes an employer must pay on employee bonuses: federal bonus taxes, additional federal taxes and state taxes.
Federal bonus taxes
As previously stated, the federal bonus tax rate is 22%. However, federal bonus taxes work a bit differently depending on when they are given to employees. If you issue bonuses via paychecks that are entirely separate from your employees' usual paychecks, you withhold taxes at the federal 22% flat rate. This is called the percentage method. If you add your employees' bonuses to their next regularly scheduled paycheck, you use the aggregate method. We'll explain more about each of these methods below.
Additional federal taxes
In addition to the federal bonus tax, bonuses are subject to Social Security and Medicare (FICA) taxes. As with standard wages, the 2020 Social Security tax rate on bonuses is 6.2% on the first $137,700 you pay each of your employees. Likewise, the 2020 Medicare tax rate is 1.45% on all wages, including bonuses, under $200,000 and 2.35% for any wages above $200,000. In many cases, for bonus withholding calculations, you can use the cumulative Social Security and Medicare tax rate of 6.2% + 1.45% = 7.65%.
State bonus taxes
After you calculate how much federal bonus tax and FICA tax you should withhold from the bonuses, you should calculate the state bonus tax. This is typically the final tax in the process.
Most, but not all, states assess taxes on bonuses. Some states even have different bonus tax rates for different types of bonuses. In California, for example, the state supplemental wage tax rate is 6.60% and increases to 10.23% on bonus and stock options. Additionally, in Maryland, you'll need to add your local tax rate to the 5.75% state bonus tax rate before calculating how much state bonus tax you must withhold. Consult a list of state bonus taxes to determine your withholding requirements.
Key takeaway: There are three types of bonus taxes: federal bonus taxes, federal FICA taxes and state (and sometimes local) bonus taxes.
How to calculate bonus taxes
Now that you know the types of bonus taxes you'll need to withhold, you need to be clear on how to do the proper calculations. After all, as previously mentioned, you calculate bonus tax withholding differently if you pay your employees bonuses as separate paychecks instead of as additions to regularly scheduled paychecks. In the first case, you'll use the percentage method, and in the second, you'll use the aggregate method.
Tax liabilities and the percentage method
For example, let's say your company is based in a Colorado city with no local bonus tax and you pay an employee a $1,000 bonus that is delivered via a check or direct deposit separate from a regularly scheduled employee payment. In this case, you calculate the federal bonus tax using the percentage method.
Start with the 22% federal bonus tax:
$1,000 x 0.22 = $220 in federal bonus taxes
Next, calculate the FICA tax withholding:
$1,000 x 0.0765 = $76.50 in FICA taxes
Finally, calculate the state bonus tax withholding using Colorado's 4.63% state bonus tax rate:
$1,000 x 0.0463 = $46.30 in Colorado state bonus taxes
When you add all of the bonus tax liabilities together, here's what you get:
$220 + $76.50 + $46.30 = $342.80 in total bonus taxes
As such, the bonus you issue to your employee will ultimately not be $1,000, but instead $1,000 minus $342.80, which equals $657.20.
Tax liabilities and the aggregate method
Let's again say your company operates in a Colorado jurisdiction with no local bonus tax. If you pay that same $1,000 bonus to an employee as part of a regularly scheduled paycheck instead of as an entirely separate payment, you calculate your federal bonus tax using the aggregate method.
In the aggregate method, the 22% federal bonus tax rate never comes into play. Instead, you use standard federal income tax tables to calculate the tax withheld from the bonus you're paying. So, if you give this $1,000 bonus to an employee whose monthly salary is usually $6,500, you're effectively paying this employee $7,500 for the month.
As such, the employee's effective yearly salary for the month isn't their usual $6,500 x 12 = $78,000. Instead, it's $7,500 x 12 = $90,000. Whereas the employee's standard $78,000 annual income translates to a federal income tax rate of 22% (assuming the employee is a single filer who isn't the head of a household), their $90,000 effective yearly salary with the bonus falls into a higher federal income tax bracket for which taxes are assessed at a 24% rate. This is the rate at which you'll withhold taxes on the bonus you're paying.
As such, your federal bonus tax withholding isn't $220 as in the previous example. Here's how to calculate it:
$1,000 x 0.0024 = $224
The FICA tax and state bonus tax calculations remain the same.
Notice that the aggregate method required much more work for a $4 increase in federal bonus tax from the percentage method. Because the aggregate method can result in higher bonus tax withholding and is more tedious to calculate, many employers prefer the percentage method.
Of course, you can't use the percentage method if you pay bonuses alongside standard paychecks. So, if you'd rather save time on calculating taxes, pay your bonuses separately from your paychecks.
Key takeaway: Use the percentage method to calculate bonus tax withholding on bonuses paid separately from paychecks and the aggregate method when adding a bonus into a regular paycheck.