They say cash is king, and that’s never more true than when employers want to reward their team for a job well done.
According to the Society for Human Resource Management, 37 percent of employees prefer a cash bonus from their employer during the holidays over a gift (6 percent), an in-person or virtual party (1 percent), job security (35 percent), or an annual merit increase (21 percent).
While employee bonuses can be a great way to reward employees and boost morale, it’s important to understand the unique tax rules that apply.
Understanding the Bonus Tax Rate
The IRS considers bonuses to be “supplemental wages.” Supplemental wages are payments made to employees outside of their regular wages, including overtime, bonuses, commissions, accumulated sick pay, severance pay, and more.
In some circumstances, the IRS requires employers to withhold federal income taxes from supplemental wages at a higher rate than they would withhold from normal wages. That withholding rate depends on how much the employee earns.
Supplemental Wages Over $1 Million
Few small business owners pay supplemental wages greater than $1 million to employees. But any that do must withhold tax at the highest tax rate for any supplemental wages over that threshold. For 2023, the highest tax bracket is 37 percent.
Supplemental Wages of $1 Million or Less
Most small businesses pay employees supplemental wages of $1 million or less. Here are the withholding options.
Based on Employee’s Form W-4
You can only use this method if supplemental wages are paid with regular wages and not identified separately on the employee’s pay stub.
For example, say you’re giving your employee a $1,000 bonus along with their $2,000 of regular wages. You normally withhold tax at a rate of 10 percent. You would withhold $300 from their $3,000 paycheck ($3,000 x 10 percent).
This method usually makes sense for smaller bonuses and overtime pay because they typically don’t move the employee into a higher tax bracket.
The Flat Rate Method
The flat rate method, also known as the flat percentage method, requires you to withhold income tax at a flat 22 percent rate. For example, say you’re giving your employee a $1,000 bonus. You would withhold $220 from their bonus ($1,000 x 22 percent) plus the regular withholdings from their normal paycheck.
No other percentage is allowed if you use the flat rate method, and you can only use it if you withheld tax from the employee’s wages in the current or prior year.
The Aggregate Method
The aggregate method is more complicated. You’re required to use it if you haven’t withheld taxes from the employee’s pay before. This might be the case if your employee claims a high level of adjustments or an exemption from income tax withholding on their W-4.
Here are the steps involved.
- Identify the employee’s regular wages.
- Add the bonus amount to their regular wages and calculate the tax withholding on the combined amount based on their W-4 (or the withholding tables included in IRS Publication 15-T).
- Determine the federal income tax withholding on the combined amount.
- Identify the amount withheld from wages in the most recent pay period that had only regular wages.
- Subtract the withholding identified on the employee’s last regular paycheck from the combined withholding amount and withhold the result from the employee’s bonus.
For example, say you’re giving your employee a $1,000 bonus along with their $2,000 of regular wages. According to the IRS tables, you should withhold $359 from their pay. On the employee’s last paycheck, which didn’t include any supplemental wages, you withheld $166. On this paycheck, you should withhold $193 ($359 - $166) from the bonus, along with $166 of normal withholding from their regular salary.
This method often results in over-withholding for the employee because the tables assume that the employee is paid the higher amount every pay period. However, this can be a good thing for bonuses paid to highly compensated employees who are likely to pay tax at the highest income tax brackets.
If all of this seems a bit too complicated, just remember that you need to withhold 37 percent on any supplemental wages over $1 million and 22 percent on supplemental wages under $1 million. Also, a full-service payroll provider like Hourly can help you run a bonus payroll and automatically withhold the right amount of tax.
In addition to federal income tax, you also need to withhold:
- Social Security and Medicare taxes: Collectively known as FICA tax, you need to withhold these taxes from the employee’s bonus check at the normal rate. For 2023, that’s 6.2 percent of the first $160,200 of earnings for Social Security and 1.45 percent of earnings (with no cap) for Medicare. For any earnings over $200,000 for single filers ($250,000 for joint filers), you have to withhold 0.9 percent for the Additional Medicare Tax.
- Any applicable state or local taxes: If your employees work in an area with state and/or local income taxes, you will need to withhold the applicable state and local taxes on their bonus check. Some states have a special supplemental withholding rate, and some allow employers to withhold taxes on bonuses at the same rate as regular pay. For example, for 2023, New York requires employers to withhold 11.70 percent from supplemental pay, and New York City’s bonus tax rate is 4.25 percent. You can check with your state’s revenue department to find out if your state has a special bonus tax rate.
- Federal and state unemployment taxes: Bonuses and other supplemental wages are also subject to federal unemployment (FUTA) and state unemployment (SUTA) taxes at the same rate used for other compensation.
Grossing-Up Employee Bonuses
Sometimes, you might want an employee to receive a certain amount. After all, a $1,000 bonus might be really generous but feel less so once you’ve withheld federal, state, and local income taxes and payroll taxes.
You can make this happen by grossing up the bonus. A bonus gross-up increases the total bonus amount so the employee gets the exact amount you want them to have after taxes.
Here are the steps to calculate a bonus gross-up:
- Add up the applicable federal, state, and local tax rates and convert to a decimal
- Subtract the total tax rate from number one to find the net percent
- Divide the net payment you want to get to by the net percent
For example, say you want your employee to receive a $1,000 bonus after taxes. You’re using the flat percentage withholding rate of 22 percent, Social Security tax is 6.2 percent, and Medicare tax is 1.45 percent. To make this calculation a little easier, let’s assume the employee works in a state without state or local income taxes, such as Texas.
Flat Rate + Social Security Rate + Medicare Rate = Total Tax Rate
22 percent + 6.2 percent + 1.45 percent = 29.65 percent (converted to a decimal: 0.2965)
1 - Total Tax Rate = Net Percent
1 - 0.2965 = 0.7035
Desired Net Payment / Net Percent = Grossed Up Bonus Amount
$1,000 / 0.7035 = $ 1,421.46
To give your employee a $1,000 bonus after taxes, you would need to pay them a gross bonus of $1,421.46.
How the IRS Taxes Employee Bonuses
Withholding a higher rate on bonuses may result in your employee having too much withheld from their paycheck. The good news for employees is that they can get that money back. The bad news is, they’ll have to wait until they file their tax return.
At tax filing time, the IRS treats bonuses and other supplemental income just like any other income — a special, higher tax rate doesn’t apply. So if the federal withholding on the employee’s bonus was higher than necessary, the overpayment would lower the tax the employee owes or increase their tax refund.
How the IRS Taxes Employers
From the employer’s perspective, bonuses are taxed the same way as regular compensation.
For 2023, employer payroll taxes include a matching 6.2 percent on the first $160,200 of earnings for Social Security tax and 1.45 percent of earnings (with no cap) for Medicare tax.
Again, your tax professional or full-service payroll provider can assist with paying the correct employer payroll taxes on any employee bonuses.
Deducting Employee Bonus Pay as a Business Expense
Businesses can generally claim a tax deduction for the salary, wages, commissions, bonuses and other compensation paid to employees. However, the year you claim a deduction for employee bonuses depends on whether you use the cash or accrual method when filing your tax return.
If you use the cash method, you can deduct bonus payments and other employee compensation in the year they’re actually paid to the employees. In other words, you must have paid the bonus before the end of the tax year to claim a deduction on that year’s tax return.
If you use the accrual method for tax purposes, you may be able to deduct accrued bonuses. Accrued bonuses are ones you’ve agreed to pay but don’t actually pay out until the next year. To be deductible, the bonus amount must:
- Have been determined by the end of the year
- Be paid to a non-related employee
- Be paid to the employee within 2½ months of year-end (March 15 for a calendar-year company)
For example, say you have a bonus plan that puts 1 percent of new business revenue into a bonus pool at year-end, to be distributed to all employees still employed by you on February 1 of the following year. In 2023, you had $500,000 of new business revenues and five employees, none of whom are related to you.
On February 1, 2024, you pay a $1,000 bonus to each employee ($500,000 x 1 percent / 5 employees). Assuming your business is an accrual-basis taxpayer, you could deduct that $5,000 in bonuses on your 2023 tax return because you met all three tests:
- You could reasonably determine the amount to be paid
- You didn’t pay bonuses to employees who are related to you
- You paid the bonuses within 2.5 months of your year-end
Bonuses Paid to Business Owners
If your business is structured as a sole proprietorship, partnership, or LLC, you won’t be able to deduct bonuses paid to yourself or your business partners. This is because sole proprietors, partners, and LLC members are considered to be self-employed by the IRS.
What was the Bonus Tax Rate for 2022?
Wondering what the bonus tax rate was for 2022? Thankfully, most everything was the same on the federal level, though there may have been some differences in local or state bonus tax rates, depending on where you're located.
There was also an asjustment in payroll taxes, which you still had to withhold from an employee's bonus check at the regular rate. The taxable wage base for Social Security was $147,000 in 2022, while in 2023 it’s $160,200.
So, in 2022, you paid 6.2 percent in Social Security taxes on the first $147,000 of an employee's earnings and in 2023 you pay 6.2 percent on the first $160,200 in earnings. There was still no limit on the amount of earnings subject to Medicare tax in 2022.
The Bonus Tax Rate Doesn’t Have to be Confusing
Employee bonuses can be a great way to incentivize employees to meet their goals and reward them for their hard work and loyalty. Familiarize yourself with the bonus tax rate, and work with your payroll provider to calculate withholdings and pay out employee bonuses correctly.