The economy is recovering enough so that employees are finally beginning to see fatter paychecks. It probably also means the return of that great holiday tradition, otherwise known as the Christmas bonus.
Bonuses are always taxable. You do, however, have leeway when it comes to determining how they’ll be paid and the income tax withholding method to apply.
Tax matters. The boss handing out separate bonus checks is drilled deep into the American psyche. There are three ways to handle bonuses:
1. Provided employees’ regular wages are subject to income tax withholding (i.e., they don’t claim exempt on their W-4s or many allowances), you can, but aren’t required to, withhold income taxes at the flat 25% rate.
2. If you want to skip the paperwork extra checks generate, you can combine the bonuses with employees’ regular pay and withhold on the total as if it were a regular wage payment.
3. Your final choice is to have the company pick up the taxes by grossing-up the bonuses. To gross-up federal taxes, subtract the flat 25% income tax withholding rate and the full employee FICA tax rate from 1: amount of the bonus ÷ (1 – 0.25 – 0.0765) = grossed-up pay. You must also include the state tax rate in the denominator. If employees have maxed out on Social Security taxes, include only the appropriate Medicare rate (0.0145 or 0.0235) in the denominator.
Unless employees have maxed out on the Social Security portion of FICA, the full FICA withholding rate applies. For those who have maxed out, withhold Medicare taxes at 1.45% or 2.35%, if employees are subject to the 0.9% additional Medicare tax.
High earners pay more. Bonuses are supplemental pay. Under a special income tax withholding rule, you must withhold 39.6% on the amount of supplemental pay that exceeds $1 million. If a bonus will boost supplemental pay over $1 million, you may withhold 25% on the portion of the payment up to $1 million and 39.6% on the portion that exceeds $1 million, or you may withhold 39.6% on the entire payment. Key: The IRS has confirmed that the 25%/39.6% rates are the only rates that apply to federal income tax withholding, so you may ignore employees’ requests to withhold at different rates.
PRACTICE TIP: Alert Accounting after scheduling the bonus payroll, since it must ensure that there’s enough cash in the payroll accounts on the bonus payday. Also, check whether the bonuses will affect your federal and state tax deposit schedules. Reminder: If you accumulate undeposited federal taxes of $100,000 on any day in a deposit period, those taxes must be deposited by the next banking day, regardless of your regular deposit schedule.