As I mentioned in my blog on married couples and withholdings, the US government taxes wages and requires employers withhold most of those taxes from each paycheck. When you start a job, you are asked to complete form W-4. This tells your employer some information about you so they can use the best table to determine the taxes which will be withheld from your paycheck.  This is for regular wages and not for bonuses or other lump sum payments such as Restricted Stock Units RSUs) granted.

There are multiple sets of withholding tables to cover taxpayers with weekly, bi-weekly, bi-monthly, and monthly paychecks. The tables exclude a portion of pay that can be attributed to the standard deduction and child tax credits as requested by the taxpayer on the W-4.

These tables do not address bonuses, RSUs, and other situations where there are lump sum payments. Instead The IRS requires that employers withhold 22% of the payment for taxes. The exception is for employees who earn $1M or more, for whom 37% is withheld for taxes. Unfortunately, 22% is often not the correct tax rate which results in large tax payments of refunds at tax filing time. 

Let’s look at two examples. Note that I use round numbers for simplicity and not the exact standard deduction numbers, which are adjusted annually for inflation. A married couple has joint annual income of $350,000 and $26,000 of interest and dividends on investments. Then one spouse gets a $50,000 bonus. The taxes are withheld at 22% or $11,000. Their adjusted gross income (AGI) is $350,000 + $25,000 + $50,000 = $426,000. The taxable income is the AGI minus the standard deduction (or itemized deduction if that is better). Using $26,000 for the standard deduction, the taxable income in this example is $400,000. As you can see if the tax bracket table above, this places the taxpayers in the 32% tax bracket for their highest income. The withholding on the bonus was only at 22%. A portion of the bonus, $35,800 ($400,000 - $364,200), will be taxed at 32% and the rest ($14,200) will be taxed at 24%. The 22% withholdings is too low and the taxpayer will owe $3,864.

To add to the tax burden, the investment income of $26,000 is unlikely to have had any taxes withheld. If the couple had children, the bonus may have pushed them out of qualifying for the child tax credit. In this first example, the client will likely owe $8,000 - $10,000 with their tax filing.

At the other end of the spectrum is the client that earns a low base pay of $3,000/month and $60,000 of bonus and commissions with a spouse that does not work. The result is a total AGI of $96,000. This client has two children. After subtracting out the standard deduction, the taxable income is $70,000. That puts this couple in the 12% tax bracket and they qualify for the $4,000 child tax credit. The 22% tax withholding on the $60,000 is too high. This couple will get at least $6,000 as a refund. From a cash flow perspective, it would have been better for this couple to have $500 per month and no refund. 

If you receive significant bonuses (over $10,000 each year), then we should consider how to handle the withholdings. You generally have four options:

1. Wait until the tax return to calculate and pay the extra, but this might cause a small penalty/interest charge and could be a painful bill.

2. Increase your withholdings by adding a number to line 4 of your W-4, but how much? That depends on the bonus amount which you likely don’t know at the start of the year. This can also cause a cash flow issue during the year.

3. Pay an estimated tax payment when you get the bonus. You can just shoot me an email and we can calculate.

4. Ask if your company will withhold your federal tax on your bonus at 32% or 37% instead of 22% (some do and some won’t) 

As always, I am here to help you through these situations.