Why Do Bonuses Seem Taxed So Heavily?

The perception that bonuses are heavily taxed can be misleading. This article explores the reasons behind this perception, clarifying how bonuses are classified and taxed under the U.S. tax system. We will also discuss how tax withholding methods can affect the feeling of high taxes, as well as the role of state and local taxes, year-end tax liability, and the perception of high income.

Classifications and Taxation of Bonuses

Bonuses, when classified as supplemental income, are subjected to a different tax system than regular wages. This distinction is crucial to understanding why bonuses may seem more heavily taxed.

Supplemental Income Classification

The Internal Revenue Service (IRS) considers bonuses as supplemental income. Under the IRS rules, bonuses are taxed at a different rate, leading to the perception of higher taxes.

Employers can choose between two methods for withholding taxes on bonuses: the percentage method or the aggregate method.

The Percentage Method

The percentage method applies a flat withholding rate, which is 22% as of 2023. This percentage may feel high, especially for employees in lower tax brackets, as it does not benefit from the progressive nature of the tax system.

The Aggregate Method

The aggregate method involves adding the bonus to the employee's most recent paycheck, and then taxing the total at the employee's regular tax rate. This method can result in higher withholding because it pushes the employee into a higher tax bracket for that pay period.

State and Local Taxes

In addition to federal taxes, bonuses may also be subject to state and local taxes. These taxes can vary significantly depending on where the employee lives, further exacerbating the perception of high taxes.

Year-End Tax Liability

When considering the high amount of tax withheld, it's essential to remember that this is often a temporary overpayment. Individuals file their tax returns to determine any refund due, which can offset the perceived overpayment.

Year-End Tax Liability and Refunds

While the withholding on bonuses might seem high, the actual tax liability for the year might be lower, and many employees receive a year-end tax refund. This is because the progressive tax system, where higher income is taxed at higher rates, often results in a more accurate tax liability than the flat withholding rate.

If an employee's income is divided into different pay periods, the highest tax bracket may not be reached until later in the year. Therefore, during the early months, when bonuses are received, there may be more withholding than necessary.

The Perception of High Income

The perception of high taxes on bonuses is heightened by the significant increase in yearly income. When bonuses are combined with regular income, the overall tax liability may be higher.

Moreover, the way bonuses are taxed on a flat rate can make them seem disproportionately high compared to regular income. However, when individuals file their tax returns and offset these taxes against their other income, the perceived overpayment can often be recovered in the form of a refund.

For instance, an employee might anticipate paying more in taxes due to a bonus but when they file their taxes, they might find that they owe little to nothing or even receive a refund. This is because the graduated tax rates account for the higher income more effectively than the flat withholding rate.

In conclusion, the perception of high taxes on bonuses is largely due to the way bonuses are classified and the methods of tax withholding. By understanding these factors, employees can better manage their expectations and prepare for year-end tax liabilities more effectively.