Around this time of the year (December), employees start cheering about getting bonuses. However, they also usually complain about the fact that bonuses are taxed at a higher rate than other money. Or they complain about a bonus tax. Or, at least my girlfriend called me today to ask about this.
But, there is no such thing as a bonus tax.
Yes, your bonus will count towards the total tax you must pay. But, it’s taxed no differently than any other type of money, including normal salary.
The difference is the amount of money that your employer withholds on your bonus is based on your MARGINAL tax rate. Whereas the amount of money that your employer withholds on your bonus is based your AVERAGE tax rate.
Marginal tax rates are the brackets that you always hear being talked about on the news. (10%, 15%, 25%, etc.). It is the tax rate of the last dollar you earned.
For example, say you are single, with no children, and had a salary of $80,000 in 2017 (and for sake of this example, paid no state income tax, made no ira or 401K contributions, and did nothing else that would otherwise reduce your taxable income). That would put you squarely in the 25% tax bracket. Your marginal tax rate would be 25%.
However, your AVERAGE tax rate would be much less than 25%.
You actually pay no tax at all on the first $10,400 of your salary in this scenario. That is because you are able to take the standard deduction of $6,350. And, you are able to take the personal exemption of $4,050. So, the federal government isn’t touching $10,400 of that salary (not taking into account social security and medicare taxes). And, it’s this feature of the tax code that is allowing this guy to attempt to never pay tax again.
The next $9,325 of your salary are taxed at 10% (i.e. you are paying $932.50 of tax on that amount). That brings the running total of tax to $932.50 on your first $19,725 of salary.
The next $28,625 of your salary are taxed at 15% (i.e. you are paying $4,293.75 of tax on that amount). That brings the running total of tax to $5,226.25 on your first $48,350.
That leaves $31,650 left of your salary to be taxed. That entire amount is taxed at your marginal tax rate, which is 25%. You are paying $7,912.50 in tax on that amount. That brings the running total of tax to $13,138.75 on your entire $80,000 of salary.
Doing the math, we divide $13,138.75 by $80,000 and multiply by 100 to get your average tax rate. In this case, your average tax rate would be around 16.4%. This is the case even though your marginal tax rate is 25%.
The people who do your employer’s payroll are smart and know this and take it into account when they are preparing the amount to withhold from your paycheck. Therefore, they spread your total tax liability of your salary throughout the year. So, each paycheck you receive has 16.4% withheld for paying the federal government (or thereabout that much depending on what you may have put on your W-4).
But, when it comes to bonuses, this isn’t the case. At the beginning of the year, no one knew what your bonus would be, or if you would get one. So, no one took it into account when figuring your total estimated tax liability.
Therefore, when you get your bonus, the entirety of the bonus has tax withholding at your marginal rate.
For example, let’s say the $80,000 employee received a bonus of $10,000 at the end of the year. Lucky guy! That money is then dollar number $80,001 through $90,000 for the year. That entire amount is subject to being taxed at the 25% rate.
Therefore, when your employer does it’s withholding, it will withhold 25% of the $10,000 for the Federal Government. So, that is $2,500 that you won’t get when you get your bonus check.
It then seems like your bonus is being taxed at a higher rate than the rest of your money, because a higher percentage is being withheld than your normal salary. But it’s not taxed at any different rate. The withholding is just higher. This effect gets magnified as salaries and bonuses get larger and tax rates get higher.
So, there is no “bonus tax.” Just some extra withholding that must be done, because your payroll department couldn’t predict the future.
Disclaimer: This is not legal or tax advice (consult a tax lawyer or accountant for that). Just some math that I hopefully did correctly.