As the holidays approach, it’s time for businesses to consider what year-end, Christmas, or holiday bonuses they’ll give to employees. Providing year-end bonuses can be a great way to motivate employees and reward top performers. Along with deciding criteria for employees to earn bonuses, many businesses need to factor in the effect of bonuses on overall yearly compensation and taxation requirements.
As a small business owner, one might question what the best way to provide employees bonuses is while keeping taxation low. As an employee, it’s important to consider how to accept the bonus and how the different methods of acceptance will be taxed. In today’s post we answer these questions and provide additional insights into important facts regarding year-end bonuses.
From a Business Standpoint
The IRS considers any additional income provided to employees, such as bonuses, as supplemental income and thus view it as taxable compensation. The bonus is subject to standard payroll taxes like federal and state withholding, FICA, and Medicare. The good news for businesses is wage expenses are tax deductible, which means total payable business taxes may decrease during the given period.
To provide a flat amount to employees, like a $2,000 bonus after taxes, the payroll manager will need to provide the bonus in gross amount during the pay period. Doing this allows the employees to receive a lump sum bonus amount after all applicable taxes and fees are withheld. Most payroll software is able to do this relatively easily.
Another way to consider offering a bonus to employees is through profit sharing through the company’s retirement savings plan like a 401(k). Providing bonuses that go directly to employee’s 401(k) accounts means bonuses are not calculated in total yearly income for the employee and the company still receives a tax deduction. As is typical for 401(k)’s, contributions are included tax-free and are only taxed upon withdrawal; at which most employees income will be lower and thus will be taxed at a lower rate.
Accepting Year-End Bonuses As an Employee
As an employee you’re likely thrilled to receive a year-end bonus. Afterall, receiving additional compensation is always appreciated; especially during the expensive holiday season. However, before accepting the bonus with no questions asked, consider the different methods of accepting the bonus and how these might affect your taxable income. By carefully considering how to receive your bonus you may be able to save yourself significant taxation.
The IRS categorizes bonuses as supplemental income and provides two different ways to withhold taxes from bonuses: 1. the percentage method or 2. the aggregate method. Each method outlines specific regulations for bonus pay. The percentage method is typically considered the better choice between the two. This method requires a flat taxation of the bonus set at 25% by the IRS. For example, if you receive a $3,000 bonus, the amount will be taxed at a flat 25% and $750 will be withheld. This approach separates your typical salary from your bonus in terms of taxation. For employees typically paying a higher percentage in taxes, the percentage method allows the employee to keep a larger portion of the bonus. Many employers prefer offering bonuses through this method as well because the bookkeeping is simple compared to the aggregate method.
The aggregate method combines yearly bonuses with overall salary for the year. During this process, the bonus is typically included in your last paycheck of the year. Doing this increases your overall yearly salary rate and may cause your tax rate to increase. For example, an employee earning $75,000 a year who earns a bonus of $5,000, will now have a total yearly salary of $80,000. Depending on your personal situation and how you file taxes – single person, married filing jointly, head of household, etc. – this bonus may increase your tax rate and leave you to take home a lower percentage of your bonus.
For high performance earners in the top earning brackets, bonuses may greatly increase taxable income. For example, corporate and CEO-bonuses often earn substantial year-end bonuses, however, they are also taxed significantly by the IRS. Bonuses at $1,000,000 or more yearly are taxed at a mandated 39.6%, bonuses, meaning $396,000 would be withheld. That’s a significant amount of money to withhold. It is important to note that eligible tax deductions and credits may retrieve some of the money in the form of a tax refund.
If you know your taxable income for the coming year will decrease, say because your spouse is moving to part-time work instead of full-time work, you can request the bonus be given at the start of the coming year instead. This would effectively lower your taxable income for both years and allow you to keep a larger percentage of the bonus.
For more information on year-end bonuses, taxable income, and business taxes, contact TrueNorth Retirement Services to schedule a free financial consultation.
TrueNorth Retirement Services is a financial and wealth management firm specializing in personalized financial guidance to local individuals and businesses. Areas of speciality range from basic tax management and accounting services to in-depth services such as audits, financial statements, and financial planning. For a free financial consultation, please call: (801) 274-1768 or email info@truenorthwealth.com.
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