Your Money: My favorite myth: Why are bonuses taxed so high?
July 13, 2011
There are a few myths going around that I love the opportunity to squash! If you’ve ever wondered why this common phenomenon’s happen to you, read on!”Why are my bonuses taxed so high?” I hear this question, or should I say complaint, quite often. When someone receives a bonus at work they believe that it gets taxed higher than their regular income. What really happens is a very different picture. When you receive a bonus, the payroll system thinks you are going to be in a higher tax bracket overall and withholds as if that is your new pay on a regular basis. At year-end, you don’t actually pay the higher tax bracket on those bonuses, your tax rate isn’t significantly higher, and you end up getting those withholdings back when you file your tax return.This is easier to demonstrate with numbers (this example is quite simplified for ease of understanding…don’t quote me!). Let’s say you are paid twice a month. If you make $1,500 twice a month , or $36,000 per year, the tax withholding system suggests that you have 15 percent of your salary withheld for federal taxes. Now, let’s say that in your first July paycheck you get a $2,000 bonus for all your hard work. This means that the tax withholding system thinks you are now making $91,000 a year (or $3,500 twice per month). The withholding rate for a $91,000 per year salary is much higher than a $36,000 salary, and requires withholding at a rate of 25 percent instead of 15 percent. And, because income is income to the payroll system, the 25 percent rate applies to all your income that month, not just the $ 2,000 bonus.In this scenario, if that was your only bonus, your total earnings would be $38,000 ($36,000 in salary + a $2,000 bonus). When you file your tax return, your tax rate may rise a bit to 16 or 17 percent, but not the full 25 percent that you were taxed during the one paycheck with a bonus added to it. So, the extra amount that was withheld back in July gets refunded to you when you file your return.Is there any way around it? Unfortunately, your company’s accountant or payroll administrator isn’t able to adjust the IRS withholding tables, but as an employee, you are able to file Form W-4 to request the number of allowances you want to claim. If you are married with two children, you would normally claim Married and 2, but if you want a lower amount of taxes withheld you could claim Married and 8, instead. It’s important to note that this does NOT apply to a tax return…you must list your accurate dependents on your tax return…but most employers allow you to choose what you list on your W-4, given that it’s your responsibility at year-end to make up any shortfall in taxes withheld. So, if you know you have a bonus coming up, you could increase your allowances on your Form W-4 and have a lower tax rate applied to your bonus check. Once you get the bonus, don’t forget to lower your exemptions back to accurate levels again, otherwise you could find yourself in a rough spot at year-end!So, the next time you hear someone complaining about how they get ripped off every time they get a bonus, hopefully you’ll chime in and put an end to this myth!Michele Knight, owner of Knight Accounting & Technology, is a CPA and QuickBooks ProAdvisor based in Dillon. For more info and to contact her, visit http://www.cpamichele.com.
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