Good, bad or sluggish economy, there are valid reasons—mostly sustaining employee morale—to pay holiday bonuses. If your company will be doing so, the time to plan for them is now. Whether or not you’ve been through this before, here’s what you need to consider.
Although bonuses are always income and FICA taxable, how they’re paid and taxed is entirely up to you. If employees haven’t maxed out on the Social Security portion of FICA, the full FICA rate applies. You have two choices for federal income tax withholding:
- You can combine bonuses with employees’ regular pay and withhold on the total as if it were a regular wage payment.
- Provided you withhold income taxes from employees’ regular pay sometime during the current or preceding year (i.e., they don’t claim exempt on their W-4s or a high number of allowances), you can pay bonuses in separate checks and withhold federal income taxes at the flat 25% rate.
You can skip withholding if the company pays employees’ taxes by grossing up the bonuses. To gross-up federal taxes, subtract the flat 25% income tax withholding rate and the 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 the appropriate Medicare rate (0.0145 or 0.0235) in the denominator.
Special rules for high earners
If a bonus vaults employees over $200,000, you must withhold 2.35% in Medicare taxes from the bonus and all additional regular and supplemental pay for the remainder of the year. You don’t match the additional 0.9%.
For income tax withholding purposes, bonuses are supplemental pay.
Under a special withholding rule, you must withhold 39.6%, without regard to employees’ W-4s, 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. Alternatively, you may withhold 39.6% on the entire payment.
Key: The IRS recently 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 a different rate.