Are Bonuses Considered Earned Income or Filed Differently?
Understand how bonuses are classified for tax purposes, how they impact withholding, and how to report them correctly on your tax return.
Bonuses are a common form of additional compensation, but their tax treatment can be confusing. Unlike regular wages, they follow different withholding rules, affecting take-home pay and tax liability.
Understanding how bonuses are taxed ensures accurate reporting and prevents surprises at tax time.
How Tax Law Classifies Bonuses
Bonuses are considered supplemental income under U.S. tax law, meaning they are treated differently from regular wages for withholding purposes. The IRS defines supplemental income as compensation paid in addition to an employee’s base earnings, including bonuses, commissions, severance pay, and overtime. Although subject to different withholding rules, bonuses remain fully taxable.
Employers report bonuses on Form W-2, listing them in Box 1 (Wages, Tips, and Other Compensation), ensuring they are included in total taxable income. Like regular wages, bonuses are subject to Social Security and Medicare taxes. In 2024, Social Security tax applies to earnings up to $168,600, while Medicare tax applies to all wages, with an additional 0.9% surtax for earnings exceeding $200,000 for single filers or $250,000 for married joint filers.
Federal Withholding on Bonus Payments
The IRS requires employers to withhold federal income tax on bonuses using either the percentage method or the aggregate method.
– Percentage Method: A flat 22% withholding rate applies to bonuses up to $1 million in 2024. For amounts exceeding $1 million, the rate increases to 37%. This method simplifies calculations but may not match an employee’s actual tax liability.
– Aggregate Method: The bonus is combined with the employee’s most recent paycheck, and withholding is based on the total amount as if it were a single paycheck. This often results in higher withholding, especially for employees in higher tax brackets. While this method reduces the risk of underpayment, it can lead to excessive withholding, requiring employees to wait for a refund.
Role in Your Taxable Wage Base
Bonuses increase taxable income, impacting income tax, Social Security tax, and Medicare tax. If total earnings exceed the Social Security wage cap of $168,600 in 2024, only the portion up to this limit is subject to the 6.2% Social Security tax. However, all wages remain subject to Medicare tax, including the additional 0.9% surtax for higher earners.
State and local taxes also affect bonus withholding. Some states impose specific supplemental income tax rates. For example, California withholds 10.23% on bonuses, while New York applies a separate rate based on income brackets. In states with wage-based unemployment insurance (UI) taxes, a large bonus may increase an employer’s taxable payroll, potentially raising future UI tax obligations.
Reporting Bonuses on Returns
Bonuses are reported as part of total wages on Form W-2. Employees should verify that the reported amount matches their pay stubs and employer records. If discrepancies arise, they should request a corrected W-2 (Form W-2c) before filing.
Bonuses can also affect eligibility for tax deductions and credits. For example, taxpayers claiming the Earned Income Tax Credit (EITC) may lose eligibility if their income exceeds the phaseout threshold. In 2024, the EITC phaseout begins at $21,580 for single filers without children and increases with income and dependents. A large bonus could push income beyond the allowable range, affecting overall tax liability.
Comparison with Other Income Categories
Bonuses fall under earned income but are classified as supplemental wages, distinguishing them from other forms of compensation.
– Stock Options: Incentive stock options (ISOs) and non-qualified stock options (NSOs) are taxed differently. ISOs may not be taxed at exercise if holding requirements are met, while NSOs are taxed immediately on the difference between the exercise price and fair market value.
– Severance Pay: Considered supplemental income, severance may impact unemployment benefits in states that offset unemployment compensation by the severance amount.
– Commissions: Subject to the same withholding rules as bonuses but often paid more regularly, affecting cash flow and tax planning.
– Deferred Compensation: Contributions to nonqualified deferred compensation (NQDC) plans are taxed when received, often at retirement when the employee may be in a lower tax bracket. Unlike bonuses, deferred compensation allows for tax deferral but comes with restrictions and potential penalties for early withdrawals.
Adjusting Withholdings When Filing
Since bonuses are often withheld at a flat rate that may not align with an employee’s actual tax bracket, adjustments may be needed when filing. If too much tax was withheld, a refund will be issued; if too little, additional tax may be owed.
To manage withholding more accurately, employees can update Form W-4 with their employer, adjusting allowances or requesting additional withholding from regular paychecks. Estimated tax payments are another option, particularly for those receiving large bonuses who want to avoid underpayment penalties. The IRS requires taxpayers to pay at least 90% of their current year’s tax liability or 100% of the previous year’s tax to avoid penalties, with a higher threshold of 110% for high-income earners.