Updated: January 8, 2024
What is a bonus?
A bonus is a form of additional compensation that goes above and beyond what an employee typically receives in their paycheck. Bonuses are a nice way to thank and acknowledge outstanding employees for their hard work or for exceeding job expectations.
In addition, bonus pay is an important way to let your most dependable — and long standing — employees know how much you value their efforts (and may prevent them from looking for greener pastures). When it comes to awarding bonuses employers, typically reward top performers with a lump sum that is added to their regular pay on payday via direct deposit. Though bonuses can also be distributed in the form of a paper check.
While paying bonuses is fairly straightforward, it’s important to understand the tax requirements that apply to this form of compensation. Here’s a closer look.
How are bonuses taxed?
Just like regular wages, taxes must be taken out of a bonus because Uncle Sam considers them income. The way in which you calculate tax withholdings on bonus payments varies depending on how you award them to employees. If you award bonuses to employees as a separate payment and do not commingle the money with regular wages, the simpler flat bonus method can be used to determine federal withholding taxes.
Bonus tax rates for 2023-2024 to know:
- The flat withholding rate for bonuses is 22% — except when those bonuses are above $1 million.
- If your employee’s bonus exceeds $1 million, congratulations to both of you on your success! These large bonuses are taxed at a flat rate of 37%.
Pros of the flat rate method: This approach is the most straightforward and therefore simplest for you as the employer to apply.
Cons of the flat rate method: This approach may not be the most appealing to your employees. This is because most people are not in the 22% tax bracket. For employees who are high earners, the 22% percent tax may not be enough and thus the employee will end up with a surprise tax bill at year’s end. Meanwhile, for lower earners, the 22% tax may be too high.
In IRS lingo, bonuses are called “supplemental wages,” which means it’s money that an employee receives, in addition to their regular salary. When it comes to ensuring you’re applying taxes to bonuses properly, there are two ways to withhold income taxes: flat bonus calculations and aggregate.
Calculating bonus pay
If you choose to pay a bonus as part of a normal paycheck, you’ll treat the total of the regular wages and supplemental wages as a single payment for tax purposes. In this “aggregate tax” approach, the employee’s normal tax rate will apply. The IRS Publication 15-T can help you determine how to do this in detail, or click here for our aggregate bonus calculator.
Pros of the aggregate method: The aggregate method tends to be more accurate, so employees are not stuck with a surprise tax bill or too much taxes being withheld.
Cons of the aggregate method: This approach takes slightly more effort for you as the business owner to calculate.
Calculating bonus pay example
Jill is new to the team, but she has had an outstanding year. She has increased productivity and cut costs in her department by 10% this year. As a way to say thank you for her hard work, you decide to award Jill a $5,000 bonus, separate from her regular wages. Her salary is $72,000 annually , or $6,000 per month.
Since the bonus is being paid separately, you simply withhold a flat 22% for Jill’s federal taxes. For this very simple example, we are assuming Jill does not pay state or other income taxes. In this case, Jill’s net bonus pay would be 78% of $5,000, or $3,900.
In yet another example, Jill has had a really good year. No — really, really good. And you decide to pay her a $1.5 million bonus. The first million will be subject to that same 22% tax rate, which amounts to a $220,000 withholding, which reduces the bonus to $780,000 after taxes. The next half million will get hit with a 37% tax, further reducing the bonus to $405,000. That means Jill’s bonus check will need to be written for $1,185,000. Which, all things considered, is still a pretty nice payout.
Regardless of the bonus tax withholding method you use on supplemental wages, please keep in mind that bonuses are still subject to social security, Medicare, and FUTA taxes. Both methods of tax withholding require a little extra math, so we recommend using a payroll bonus calculator (try the one at the top of the page!) to make sure you’ve calculated everything correctly.
What are the different types of bonuses?
Bonuses come in many shapes and sizes and can have a variety of use cases. Some employers offer cash bonuses to convince top job candidates to choose their company (and keep them away from a competitor). In other cases, businesses may decide to reward their entire staff with bonus pay around the holiday season. It usually comes down to what makes the most financial sense, the size of the team, a company’s culture, or whether the company even realizes that using bonuses to recruit (or retain) team members is a valuable tactic. Below, we cover some examples of common bonuses employers use to make a difference with their team members.
A profit-sharing bonus can take an employee’s contributions to your company up a notch. In most cases, an employee only receives this type of lucrative bonus when the business turns a profit.
Funds to reward employees are accumulated in different ways. For example, a business may set aside a portion of its profits each year to be distributed as profit-sharing bonuses. In other cases, the funds may be accumulated over time and invested in a separate account or pool.
In order to calculate the amount of money to award an employee through profit-sharing, many companies use a formula that takes into account such factors as the company’s overall financial performance and the length of an employee’s tenure. .
Why give this bonus?
Bonuses can be a great way to help an employee feel truly invested in a company’s goals and see themselves as part of the bigger picture as the organization grows.
Typically distributed towards the end of the year, holiday bonuses can be used to express gratitude and appreciation for an employee’s hard work. Depending on a company’s policy, the size of this bonus may vary or, in some cases, may be tied to an employee’s individual performance. In addition, paid time off (PTO) is also a type of bonus employers use to reward employees as the holiday season approaches.
Why give this bonus?
Almost all employees appreciate the gesture as they get ready for the holiday season, and it can also have a long-term positive impact on your company’s productivity, morale, and worker retention.
Employers sometimes offer a signing bonus to top candidates to encourage them to accept a job offer. Most of the time, this is a one-time payment made to the new employee (and presented by a company recruiter).
Why give this bonus?
In addition to keeping competitors at bay, it lets top recruits know you mean business and can be the difference-maker that entices them to accept your offer.
Many companies give employees a bonus for referring qualified job candidates to their human resources teams (which helps bring on new employees.)
Why give this bonus?
Between social channels such as LinkedIn or job review websites, there’s many ways for candidates to learn about working at your company. Your own employees can also be an excellent method to recruit talented new staff, especially when you provide financial incentive for employees to spread the word about job opportunities.
A financial reward based on the individual’s or team’s performance, often tied to specific goals or metrics.
Why give this bonus?
Most ambitious employees want to know they’re making a difference and getting the chance to meet (and even exceed) their goals. Knowing that they have a target to hit and one that they could potentially be rewarded for financially, is an incentive that will likely encourage them to go the extra mile in their role.
Some employers provide retention bonuses to encourage their best and brightest employees to stay with the company for a certain amount of time. Do you have employees, for example, who have been with you since opening the doors and have contributed to your company’s growth (or have stuck with you through thick and thin)? Or did you use a sign-on bonus to lure an amazing job candidate that you’re hoping to hold onto for the long haul? You may want to consider retention bonuses to let them know how much you appreciate the work they do.
Why give this bonus?
This bonus can keep top performers happy and productive, and it may prevent them from leaving over the long run.
Remember that bonuses can vary greatly from one employer to another, and depend on many variables including the size of an organization, the industry they’re in, and a company’s culture or goals.
In addition, Noel offers some thoughts on how to stay ahead of the curve regarding taxes and bonus pay. “In my experience, there are some steps employers can take to ensure everything is in order,” he says. Here are some things Noel says to keep in mind.
- Stay informed: Keeping up-to-date on federal and state tax laws that apply to bonuses is essential for compliance.
- Get the math right: Employers should use accurate tax formulas to calculate the amount of tax owed on bonuses.
- Adjust as needed: Adjusting employee withholding to account for bonuses is crucial to avoid underpayment of taxes.
- Keep good records: Maintaining accurate records of bonus payments and tax withheld is a best practice in case of an audit.
- Time it wisely: When bonuses are paid, the timing can affect taxes, so employers should keep this in mind.
“By following these best practices, employers can make sure everything is on the up and up within terms to taxes and bonus pay,” explains Lorenzana. “This can help avoid potential issues and ensure that your employees are properly taxed on their bonus income.”
Other useful paycheck calculators
The calculator at the top of this page is designed to help you figure out the correct amount of federal and state taxes to withhold when rewarding an employee with a well-earned bonus. That said, there can be other scenarios when getting paychecks right requires a little more wrangling. For example, when an employee departs, you may need to issue a final paycheck. Or if you offer tipped wages or bonuses, you may need to add another step or two to your gross pay formulas for hourly and salaried employees. You may find one of our other calculators below to be helpful down the road.
This bonus calculator and others included on this page are for informational purposes only and to provide general guidance and estimates; it should not be relied on for tax, legal, or accounting advice. If you are unsure about your obligations or need assistance, you should consult your own tax, legal, or accounting advisor for formal consultation.