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Monday, January 4, 2016

Why is my bonus taxed more than regular income? (Hint: It's Not!)

If I go back and look at the paycheck in which I received my "bonus" check in 2015, I note that the amount of federal income tax is a much larger percentage of the total bonus than the amount of tax on a normal paycheck.

What's the deal here? Why does the government take more of my bonus than my regular income?

The answer hinges on the fact that the amount of money withheld from your paychecks for taxes is not the same as the amount of tax that you actually owe for the year. The whole point of filing a tax return in the spring is to calculate whether the income tax withheld from all your paychecks is equal to the amount you actually owe for the year (your "tax liability). It's almost never exactly correct, which is why you get a refund (because a bit extra was withheld from each paycheck throughout the year) or a bill (because not enough was withheld).

The bottom line is that bonus income is taxed exactly the same as regular income. It is simply withheld at a different rate. Federal income tax withholding on your normal paychecks is based on how much you make, and the number of "allowances" you requested on your W-4 (more allowances cause less tax to be withheld from each check). Yet for bonus income, many large companies will have taxes withheld at a flat rate of 25%. (Note). For most employees this will be well above your normal withholding rate.

As such, you will effectively get that extra money back at tax time. Example:
  • ​Total ("Gross") Bonus: ​$4,000 
  • Taxes Withheld (25%): ​$1000 
  • Theoretical "correct" withholding, supposing your effective tax rate is 15% : $600
  • "Extra" withheld​: $400​
In this example, your tax refund will be increased by $400 when you file your tax return (Or if applicable, your bill will be reduced by that much)
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In summary, although your bonus may have taxes withheld at a higher rate, any surplus withholding will be returned to you when you file your tax return.

2 comments:

  1. So government gets to use my money for free until I can legally get it back. Since its my money anyway, why not give me the courtesy of giving me interest equal to the inflation rate.

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    1. Great point! However, you can set up your withholdings to account for your bonus. Ask your employer how to change your withholdings, or where to fill out form W-4. Then run your situation through the IRS withholding calculator. You should be able to get your withholdings set up for just about a $0 balance due at tax time, even with a bonus.

      https://www.irs.gov/Individuals/IRS-Withholding-Calculator

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