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This article was fact-checked by our editors and CPA Janet Murphy, senior product specialist with Credit Karma Tax®.
You’ve worked really hard to earn your bonus — congratulations!
Of course, any time you receive income, there are potential federal tax implications. Your bonus is no different. That said, you might be able to take some steps that will help minimize any tax on your bonus — just like on your other income.
- Bonus basics
- Pick your withholding rate
- Offset the bonus tax with deductions
- Mitigate the bonus tax with contributions
- Ask your employer for workplace perks instead
The IRS considers cash bonuses “supplemental wages,” which means you could have to pay income tax on it, like you do on your regular salary or hourly wage.
Your employer will take the taxes on your bonus out of your paycheck for you, so you don’t have to figure it out on your own. If your employer pays it to you as a separate payment from your normal paycheck or specifies it as a separate line item on your normal paycheck, it will hold back 22% of the cash to go toward your tax bill (regardless of your tax bracket).
But if it’s combined with your regular paycheck in one lump sum, it will withhold at the same tax rate it does for the rest of your regular income, which depends on your tax bracket.
In either situation, wouldn’t it be nice if you could keep as much of your bonus as possible? Let’s explore some actions that might be able to help you do just that.
Pick your withholding rate
How your employer handles your bonus can make a big difference in how much tax you’ll pay on it.
If you are in a tax bracket lower than 22%, having your employer treat your bonus amount as a separate payment would mean paying tax on it at a higher rate. In that scenario, you might be better off if your employer includes your bonus with your regular pay so that you pay less tax.
Conversely, if you’re in a higher tax bracket, 22% may be a lower rate than what you pay on your regular wages. In that case, you’d come out ahead by having your employer treat your bonus as a separate payment, so that you pay less tax on it.
There’s a $1-million cap to those rules though. If your supplemental compensation for the tax year exceeds $1 million, your employer should withhold any amount up to $1 million at 22% but then withhold 37% (or the highest rate of income tax for the year) on the amount exceeding $1 million.
It’s up to your employer how to handle tax withholding on your bonus, but there’s probably no harm in asking to take the route that will minimize your tax. And don’t forget that no matter how your employer treats your bonus, you’ll still have to pay Medicare and federal unemployment tax on that amount.
Offset the bonus tax with deductions
Deductions allow you to reduce your taxable income for the year, something that could reduce your tax liability and help you owe less at tax time.
For example, if you earn a $5,000 bonus at work and can claim a $5,000 deduction, then you essentially would cancel out the tax impact of that income. In other words, you could effectively earn your entire bonus, tax-free, by taking a qualifying deduction for the same amount (or more) than your bonus.
Donate the money to charity
If you don’t need the cash and are really passionate about a certain cause, another option is to donate the money to an eligible charity. The charitable deduction is a popular tax break.You can typically deduct donations of up to 60% of your income for a given year (that’d be a huge bonus!).
Before you hand over your bonus, you’ll first need to make sure that the charity is indeed eligible to receive tax-deductible charitable donations in order for you to claim it as a deduction. You can check the IRS’s website for groups that are eligible.
Most taxpayers get a choice in how to take deductions on their federal income tax return. You can either tally up all the individual deductions you’re eligible for and “itemize” your deductions, or you can take the “standard” deduction for your filing status.
What are the standard deductions for 2018?
Here are the standard deductions for 2018.
● Single, or married filing separately — $12,000
● Married filing jointly, or qualifying widow or widower — $24,000
● Head of household — $18,000
Learn more about the standard deduction here.
These standard deductions are higher than in previous years because of the passage of the Tax Cuts and Jobs Act in 2017. Experts estimate that because of the higher standard deduction, only 10% of filers will be eligible for a smaller tax bill when opting to itemize their deductions.
This is an important point, because if you choose to take the standard deduction, the IRS doesn’t allow you to claim certain itemized deductions, like charitable donations. However, there are a few exceptions, which we’ll note below.
Mitigate the bonus tax with contributions
Traditional IRA, SEP IRA or your workplace 401(k)
Did you know that the Social Security Administration itself expects the fund to run dry by 2037 unless significant changes are made? Putting as much as you can into retirement savings now could mean that when you retire, Social Security might be the icing on the cake, rather than the main course.
For our purposes, another great benefit of contributing to certain retirement accounts — like a traditional IRA or employer-sponsored 401(k) — is that you can generally take a tax deduction for contributions to your account, up to the annual limits. Even better, you can still take this deduction even if you opt for the standard deduction.
Additionally, the total amount you can contribute to all your retirement plans is $18,500, or $24,500 if you’re 50 or older.
Health savings accounts
If you carry a high-deductible health insurance plan (one with at least a $2,700 deductible for families, or $1,350 deductible for individuals), you are allowed to save up for qualified health costs within a special type of tax-advantaged account: an HSA (or health savings account).
You can save for future medical bills and write off the same amount you save on your taxes (even if you opt for the standard deduction). Tax savings and money for health expenses: It’s a win-win scenario.
For 2018, you can contribute to your HSA — and deduct from your taxes — up to $6,900 for a family, or $3,450 if you’re an individual.
Ask your employer for workplace perks instead
Finally, you can consider asking your employer to reward you with some kind of nonmonetary workplace perk instead. Think about what you’d really like in the workplace.
● More paid time off
● A dedicated parking space
● A partial work-from-home arrangement
● A raise
These things can serve as a reward without requiring you to pay tax on a bonus. But be careful what you ask for — the IRS considers fringe benefits taxable, in which case they’re taxed in the same way as supplemental income. Check out IRS Publication 15-B for a list of fringe benefits that aren’t taxed.
While bonuses can really make your day, paying taxes on them can also put a damper on the fun. Still, count yourself lucky — earning too much income is a good problem to have! And getting a bonus doesn’t mean you can’t also get a tax refund, depending on your tax situation.
Remember, though, your employer will take federal withholding taxes out of your bonus for you, which could help reduce the risk that you’ll end up facing a huge tax bill come Tax Day. But if you’d still rather keep as much of your bonus as possible, these steps may help you keep a little more of your reward for working hard.
Relevant sources: IRS Publication 15, Employer’s Tax Guide | IRS Notice 1036, Percentage Method Tables for Income Tax Withholding | IRS: Credits and Deductions for Individuals | The Tax Cuts and Jobs Act of 2017 | IRS Tax Exempt Organization Search | IRS Publication 526, Charitable Contributions | IRS: Itemizing vs. Standard Deduction: Six Tips to Help You Choose | IRS: Steps to Take Now to Get a Jump on Next Year’s Taxes | State of New Jersey, Department of Education | Social Security Administration, Office of Retirement and Disability Policy | IRS: Retirement Topics – IRA Contribution Limits | IRS: IRA Deduction Limits | IRS: Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits | IRS: How Much Salary Can you Defer if You’re Eligible for More than One Retirement Plan? | IRS Revenue Procedure 2017-37 | IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans
A senior product specialist with Credit Karma Tax®, Janet Murphy is a CPA with more than a decade in the tax industry. She’s worked as a tax analyst, tax product development manager and tax accountant. She has accounting degrees and certifications from Clemson University and the U.S. Career Institute. You can find her on LinkedIn.