2025 Bonus Taxation: Examining the Taxation of Extra Payments

Bonuses can be a significant part of an employee's income, but they also come with tax implications. Here's a breakdown of how bonuses are taxed, and strategies to lower your tax bill.

Firstly, it's important to know that employers must withhold some of the money from bonuses to send to the IRS for taxes. The IRS classifies bonuses as "supplemental wages," which also includes severance pay, commissions, and awards and prizes.

Employers typically calculate taxes on bonus payments using the "sonstiger Bezug" (special payment) method. This method involves calculating the annual income with and without the bonus to determine the tax difference that is withheld from the bonus. This method is generally more favourable than taxing the bonus as regular monthly salary because it accounts for tax progression over the year.

However, if a taxpayer expects their income to be much lower the next year, they can consider asking their employer to defer the bonus until then. If supplemental wages for a year total more than $1 million, the employer must use the flat rate method and calculate bonus withholding over $1 million at 37 percent.

One strategy to lower the tax withholding on a bonus is to stash it into a pre-tax account such as a 401(k) or IRA. By doing so, you reduce your taxable income. Another way is to ask the employer to pay the bonus separately and calculate tax withholding at the 22 percent flat rate allowed for supplemental wages.

The IRS tax withholding estimator is a useful tool for figuring out the correct amount of money that should be withheld for taxes. It's also crucial to remember to take advantage of any tax deductions and credits that might be eligible to reduce the taxable income and tax bill.

When too much is withheld from a bonus, the employee should receive a tax refund when filing their tax return. If a bonus amount exceeds $1 million, the withholding rate for any amount above $1 million is 37 percent.

It's worth noting that the IRS considers bonuses to be "supplemental wages," which are payments to an employee that aren't part of their regular wages. Examples of supplemental wages include, but aren't limited to: bonuses, certain commissions, overtime pay, accumulated sick leave, severance pay, prizes and awards, back pay, reported tips, retroactive pay increase, payments for non-deductible moving expenses, and payments for non-deductible moving expenses.

The exception to the rule of taxable bonuses is if they qualify as an employee achievement award, under certain conditions. However, these conditions are quite specific and may not apply to most bonuses.

In conclusion, understanding the tax implications of bonuses is crucial to managing your finances effectively. By being aware of the strategies to lower your tax bill, you can make the most of your bonus payments.