However, an annual bonus isn't just a gift with no strings attached. If you give a bonus, your employees need to pay taxes on that money just like any other paycheck. That can take the wind out of their sails, especially if they need clarification on what tax rules apply to annual bonuses and who is responsible for paying them.
An annual bonus is considered taxable income but falls under a different category than a regular paycheck. An annual bonus is considered supplemental income, meaning the tax withholding on bonuses requires more consideration.
As an employer, you are responsible for calculating the withholding on annual bonus checks each year. You can do this in two ways, impacting your employees' tax liability for the year and how much money they will receive in their paychecks.
The percentage withholding method is typically used if a bonus is paid separately from a regular paycheck. In this case, the IRS requires a flat rate of 22% to be withheld from the bonus if it is under $1 million. However, if the bonus is over $1 million, any money after the first million is withheld at 37%.
While easy for businesses to calculate, this method can confuse employees come tax time. If their tax bracket is below 22%, they will obtain part of their bonus once they file tax returns and receive a refund. However, if their tax bracket is over 22%, they will have to pay an additional expense when they file their return.
You can also use a second withholding method called aggregate withholding. This method involves giving a bonus in regular paychecks, not as a separate payment. You will then withhold the rate that employees have on their filing status based on their tax information and W-4.
While this might be more work for your payroll department, this method tends to be more accurate than flat percentage withholding.
As a result, employees are less likely to receive an unpleasant surprise when they file taxes. They will also receive their bonus when you give out paychecks without waiting for a tax refund.
How you choose to distribute a bonus is up to you. For example, some companies prefer to add the bonus to a direct deposit paycheck to qualify for aggregate withholding.
In contrast, some other businesses will choose to cut an extra check for employees for a percentage withholding method.
Your company policies can also impact bonuses. For example, some businesses give out bonuses at the end of the calendar year around the holiday time as an extra gift, while other companies will send them out at the end of the fiscal year or around tax time in spring. Again, think about what makes the most sense for your payroll and company culture.
If your employees are concerned about annual bonus expenses, you can use a few methods to help prepare them for what to expect and minimize any negative impact.
Not all bonuses are straight cash added to a paycheck. Sometimes you might give out a bonus as a perk, like you would game tickets or vouchers. These typically aren't taxable gifts. However, lump sums of money, gift cards, and expensive gifts can be taxable.
Ensure you clarify with your employees that their annual bonus counts as supplemental income.
Rather than take a bonus as cash, your employees can use a bonus towards a qualifying contribution to a tax-advantaged account, such as an IRA, HSA, or 401K account. The money in these accounts is pre-tax, so they can avoid paying high rates for the total income for the year.
If an employee is concerned about taxes for the current year, they might approach you about deferring their bonus for another year. While this doesn't eliminate the need to pay taxes on the money once they receive it, it can help them avoid moving into a new tax bracket with higher rates or having additional taxable income before they are prepared.
Sometimes it can be overwhelming to understand the best choice for giving bonuses. That's where Exact Payroll comes in. Partnering with an established tax agency and working with a professional payroll company can help you determine the best possible option to approach yearly bonuses and how you distribute them.
At Exact Payroll, we understand how important it is to take taxes seriously and make sure that you make vital financial decisions for your future. Contact us today to learn more about our services and how we can support you.