If you are fortunate enough to be employed in this sluggish economy, that's good news. If you're even more fortunate to receive a bonus check, then you probably noticed a sizable percentage of that bonus check was lost to taxes.
Uncle Sam wants part of your bonus
The Percentage Method isn't a household name, yet it affects many Americans even if they know nothing about it. It's time to get educated. This is the method by which taxes are withdrawn from your bonus check. It's not necessarily fair or favorable if you're an average taxpayer.
At the federal level, this is a flat tax of 25% that's withheld from your bonus. It's a flat percentage at the state level as well, and the number varies depending on which state you are in. A flat tax is the same, no matter your income level or tax bracket. Even if usually get to keep 90% of your check, this flat tax is applied to your bonus check no matter what.
What can you do?
This flat tax is hard to avoid. We all hear about what happens to those who don't pay their taxes. They are fined or, if the dollar amount is high enough, must serve time in jail.
Is there any way to reduce the taxes on your bonus check? Sometimes you can reduce your taxes, depending on the situation. One way to avoid paying too much in taxes is to plan ahead. If you know that a bonus is in the future, increase your withholding allowances during the year. Withholding allowances during the year will translate into less income tax being withheld from your regular paychecks. This will in turn offset the high tax withholding from your bonus which will result in paying fewer taxes all the way around.
That's not your only choice. You might also want to raise your withholding allowances after you get the bonus and then fewer taxes are withheld for the rest of the year. Either way, you are paying less in taxes.
Not as easy as it sounds
Most of the time, a bonus check comes at the end of the year. So these are difficult strategies in that you don't want to risk under-withholding unless you are absolutely sure the bonus is coming. Otherwise it could turn into quite a mess.
The Aggregate Method might be better for your situation. Allowed in many states, the aggregate method bases the amount of tax withheld on your wages. It also takes into consideration your tax withholding up to the date of your bonus check. The Aggregate Method allows your taxes to be calculated like your bonus is just a regular paycheck.
You will still be paying taxes. The Aggregate Method won't change that. Unfortunately, payroll software doesn't have the ability to recognize that your bonus is simply a single payment. In other words, the payroll software just assumes that your bonus check for ,000 is a regular payment that will increase your annual income. For just that one bonus, the software thinks that more taxes need to be withheld because it thinks you are now in a completely different and higher tax bracket. So it taxes you at that higher rate. Even with bonuses that are smaller, too many companies never realize there is a method to this madness and as a result, too many incorrect software calculations create bigger bonus problems for employees who'd like to keep as much of this extra money as possible.
The problem with bonuses
Even if your employer is on top of things and figures out your bonus correctly, your bonus is probably a higher dollar amount. It's usually higher than your regular paycheck and therefore there will be more taxes withheld. Such taxes are usually magnified. So this leads you to receive a smaller bonus check than you expected.
What else? If you are in a high tax bracket, and your employer uses the percentage method to determine the tax rate, you might end up under-withheld at the end of the year. For example, perhaps your federal tax rate is 35%, and only 25% is withheld. If you believe this could happen, call Human Resources or your Payroll Department and request that more taxes are withheld from your bonus check. Your employer is authorized to withhold more if you ask them. They just wouldn't be able to withhold less.
If you are getting a bonus and want to determine how much of the bonus you will get to keep, check out bonus calculators online. While you're at it, research the many ways you can understand your paychecks. You can learn about different numbers of allowances and how those different scenarios affect your withholding situation. You can find both regular paycheck and bonus calculators as well. Make sure to select your state to get accurate results.
Catherine Durkin Robinson is a contributing writer for BillSavings.com, your information resource and community for money-saving tips and offers so you can shop, compare, and save money on just about everything.