Getting a year-end bonus can be thrilling, but you might be disappointed with the amount that actually hits your bank account.
That’s because the 2021 bonus tax rate is 22%, so employees might see their bonus taxed at a higher rate than their typical income. The exact bonus amount you receive after taxes will depend on how your employer handles withholdings and the amount of the bonus.
The Percentage Method
A bonus is considered ordinary income, making things pretty simple at the outset. However, when employers choose to withhold taxes on that bonus at a higher rate, you might see a smaller chunk of cash in your account than you were anticipating.
“Most people don’t realize that it’s not that bonuses are taxed any differently than ordinary income, but the withholding your company does is probably higher,” says Kyle Moore, a certified financial planner and founder of Quarry Hill Advisors. “The money might be taxed higher than the money you typically earn because we have a progressive tax system.”
Employers generally have two options when it comes to withholding a bonus: the percentage method and the aggregate method. Generally, opting for the percentage method is the most simple route for employers, making it the more common method employees can expect to encounter.
Employers using the percentage method of withholding will pay employee bonuses separately from regular salaries, and those bonuses will be subject to a flat bonus tax rate. For bonuses of less than $1 million that are paid in 2021, the bonus tax rate is 22%. A bonus of more than $1 million will be taxed at the highest rate of income tax allowed by federal law, which is 37% in 2021.
In this case, your bonus is being treated as supplemental income, defined as extra money outside of your regular salary, and you may receive a refund at the end of the year if the total of your taxes withheld exceeds your actual liability for the year. If an employee is typically in a lower tax bracket, this method can be less desirable than the aggregate method.
[READ: Your Guide to 2021 Tax Deductions.]
The Aggregate Method
If your bonus is added to your regular paycheck, your employer is using the aggregate method, meaning taxes are withheld at your typical rate according to the details you provided in your W-4.
You’ll still notice your employer withholding more money than usual, but you won’t be subject to the flat bonus tax rate. Use this IRS tax withholding estimator to calculate what you might owe.
Employees who would prefer one withholding method over the other should speak with their payroll department and consider filing a new W-4 as needed.
[READ: What to Know About Sign-On Bonuses.]
Tax Planning Tips for Your Bonus
Regardless of how your employer chooses to pay you a bonus, there can be significant tax consequences. A bonus could bump you up into a higher tax bracket, for example, or a bonus could be an opportunity to avoid higher taxes in future years — what matters is how you plan for that bonus.
“There are a few levers you can pull,” Moore says. “If you think tax rates are going up, you might want to defer more into a 401(k) if you can. If you’re a W-2 employee, maybe you have an HSA you didn’t take advantage of that can reduce your income. If you have tax losses in a taxable investment account, you could deduct up to $3,000 of that to bring down your income also.”
[See: 15 Tax Questions Answered.]
Timing your bonus is also a critical tax-planning opportunity, according to Martin Kamenski, CEO of Revel CPA. Some employers pay employee bonuses at year’s end, while others pay in January or February of the new year.
To time your bonus properly, you need to know which tax bracket you’re in, the expected bonus amount, and whether your employer is willing to be flexible with bonus payments.
“If a taxpayer is in a situation where they have the ability to recognize or not recognize some income in a certain year — such as year-end bonuses, when a company might give you the option to have that bonus paid out the week of Christmas or in early January — knowing where you fall within your tax bracket and how much room there is before that tax bracket is reached could weigh in on your decision.”
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Bonus Tax Rate in 2021: How Bonuses Are Taxed originally appeared on usnews.com
Update 12/21/21: This story was published at an earlier date and has been updated with new information.