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Receiving a bonus at work usually happens toward the end of the year. Employers pay bonuses as a reward to employees for their hard work during the year, with many companies using a bonus as an incentive to motivate employees. While a bonus represents a great windfall, determining what kind of income category the bonus falls under sometimes proves difficult.

The Internal Revenue Service considers a bonus as a supplemental wage. According to the IRS, a bonus represents compensation paid outside of an employee’s regular wages. Other types of supplemental income include severance, vacation, back pay, moving expenses, overtime, commission and some fringe benefits.

How is tax applied to a bonus?

While bonuses represent a great way to motivate employees, bonus taxation presents its own hurdle come tax time. Two circumstances exist for taxes on bonuses, including the following:

  • Percentage: If taxing the bonus using a percentage, the IRS takes a flat 25 percent of the bonus in taxes.
  • Aggregate: If your employer elects to go the route of the aggregate method when giving out a bonus, then the employer determines the normal withholding amount based on IRS tables for both your normal pay and the bonus amount. The employer then subtracts what already was withheld from the regular paycheck from the previous pay period and withholds the remaining amount from the bonus payment.

Out of the two methods above, the flat 25 percent represents the most straightforward and easiest to implement. Using the flat 25 percent for bonus checks also ensures that you do not worry about the IRS taking too much from your weekly check in taxes, leaving you short of your regular pay.

Paychecks following a bonus

When initially taxed, you might think that your bonus was taxed at a higher rate than your regular pay. Fortunately for you, this is not the case.

If you receive a bonus early enough in the year, the rest of your paychecks for the year reflect this in the form of a lower withholding amount on each check. The IRS knows how much you are expected to make by year’s end by estimating it, using your average weekly or monthly pay.

When you receive a bonus, the IRS recalculates the amount you need to pay in taxes by taking into account the windfall and adjusting the percentage you pay in taxes each pay period. This way, you do not pay more in taxes on a bonus; you just receive more in your regular paycheck to accommodate this change.

Good uses for a bonus

To make the most of your bonus, you should seriously consider what your range of options are. Spending a bonus gives you instant gratification, but you should weigh putting your bonus to work to make you even more money.

  1. InvestInvesting a bonus represents one way of making that supplemental cash work for you. Investing in a tax-deferred account means not only does the bonus make you money, but, until you withdraw those funds, they remain tax-free.Some examples of a tax-deferred account include individual retirement accounts and deferred annuities.
  2. 401(k)Placing a bonus into your 401(k) account represents another great way to make your bonus check work toward your retirement.Just make sure that your employer allows you to contribute using a bonus and that the bonus does not put you over your annual limit on contributions. Also consider staggering your contributions from your bonus check to take full advantage of your employer’s matching contribution.
  3. Health savings accountIn addition to a 401(k) or IRA, you can contribute to your health savings account, if your company offers one. An HSA allows you to contribute funds to the account to spend on qualified medical expenses.Many HSAs allow you to deposit pretax dollars and grow the money in the account tax-free. Some employers allow you to invest the money in the account in mutual funds and other investments to grow the amount over time.

    Talk with a financial adviser to determine if your income limits contributions or whether you can deduct all of your IRA contributions if you or your spouse participates in another retirement plan.

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