Just like regular salary amounts, bonuses are subject to graduated federal income tax rates. Those rates range from a low of 10 percent to a high of 39.6 percent, depending on your filing status, (married, single, etc.) and the amount of your income subject to tax. For married individuals, 2015 taxable income in excess of $151,200 will be taxed at rates between 28 percent and 39.6 percent.
Employers determine how much federal income tax to withhold on regular salary based on information you provided on the W-4 form when you started work. The tax your employer withholds on each paycheck is based solely on an estimate of the taxes you will owe on your base salary. Using the same tax rate on your bonus can result in too much or too little tax being withheld.
To prevent an excessive amount of tax from being withheld on bonuses, employers typically use a flat tax rate such as 20 percent or 25 percent for withholding federal income tax on bonuses. The IRS suggests a default rate of 25 percent withholding on bonuses, but the actual withholding rate used is at your employer’s discretion. Problems will arise when your employer withholds too little income tax. A 25 percent withholding rate when your income is actually subject to a 39.6 percent rate can leave you with an unpleasantly large tax bill come April.
Consider, for example, a professional athlete with a $435,000 base salary, zero exemptions on his W-4, and a $1 million signing bonus. After taking his tax status and deductions into account, the withholding on his base salary should cover the taxes on his regular salary. His million dollar signing bonus, however, puts him in the top bracket of 39.6 percent while his team only withheld taxes at its default 25 percent rate. His actual liability on the bonus will be $396,000, but only $250,000 had been withheld. That leaves a $150,000 balance due; an unpleasant surprise that could have been easily prevented with proper tax planning.
Employees need to be aware that the default withholding on their bonuses may not reflect their personal tax rate, and employers should evaluate current federal tax policy to determine if their default withholding rate on bonuses is still valid.
If both the employee and the employer do not consider the tax ramification of a bonus plan, a great motivating tool and sign of appreciation could lead to unpleasant tax surprises.
Published on PICPA.org