Do I Have to Pay Taxes on My Christmas Bonus?
If your employer rewarded your hard work with a year-end bonus, you are typically required to pay taxes on this. Even if when the bonus is not tied to a number of hours worked or the completion of a particular project, the government still considers this income as wages. These are referred to as supplemental wages. Bonuses fall into the same category as your vacation pay, overtime, severance pay, and commissions. However, the IRS treats supplemental wages differently than regular wages with respect to withholdings, and offers employers two different ways to calculate how much to deduct before handing out the bonus to employees.
Here's a brief explanation of the two methods employers can use to deduct taxes from bonuses. You likely can't control which method your employer uses, but it's a good idea to try and better understand them.
The IRS allows your employer to separate the bonus from your regular earnings and deduct a flat-rate of 25% from the amount. Your employer may choose the flat-rate method because it's a fast and easy calculation for the payroll department to perform, and easy to explain to you as the bonus recipient. Say for example, you receive a year-end bonus of $2,000. If your employer uses the flat-rate method in this scenario, $500 would be withheld for federal income taxes, and the rest passed on to you.
Your employer may also choose to use the aggregate method. In this method, your employer adds the bonus to your regular paycheck instead of separating the amounts. Payroll then consults the IRS withholding tables to figure out how much tax to deduct on the larger amount. So if you normally earn $3,000 a month ($36,000 annually), and your employer gives you a $2,000 bonus, then for tax purposes, the aggregate method treats the amount as though you got a $2,000 raise (in other words $38,000 annually).
Some taxpayers may find this method problematic because, depending upon the company/software processing the payroll, the new tax rate may carry over into the next year. If you receive an annual bonus that is a large portion of your annual income this may be particularly problematic.
If your employer does withhold more tax than is necessary, you will typically recover this when you file your taxes, which take your actual earnings for the year into account. Nonetheless, most want their money sooner and do not want to wait on the government for a refund.