What to Do About… Bonuses

Photo by Jason Rojas on Unsplash

Right about now, you may be asking yourself, what do you mean "what to do about bonuses?!" And I get the confusion, I mean what's the problem with a sudden lump sum of money that's given to you, who doesn't love that?!

But people often don't stop to think about the taxes surrounding that lump sum of money and how that may affect their tax bill when April comes around. Let's take a moment to go beyond the initial excitement of receiving a bonus and talk about a few methods of handling the withholding portion of your bonus to minimize the chances of a large tax bill (and a tax penalty).

A good portion of our clients work for a large investment firm and generally receive bonuses in April and either June or August. One nice thing is that because we know when to expect the bonuses, we can plan ahead. There are 3 main methods that we discuss with our clients from which they choose a path that they prefer.

The problem

But first, let's talk about what the issue is.

The core problem is underwithholding. What does that mean? It basically means not enough tax is withheld from your paychecks to pay your tax bill.

Tax time comes around, and you find out you owe a bunch of money. No fun. And, even worse, there's a good chance you'll also owe a penalty for that underwithholding. No bueno. No one likes to pay a tax penalty.

So why does this happen? Because taxes on bonuses for most employers are withheld at a different rate than the rest of your paychecks. The default in the United States is that your employer probably withholds taxes at 22%. Why? No clue. But it sure does cause problems.

The problem is... what if your tax rate is above 22%? Well then you're likely to be underwithheld.

An example, por favor?

Let's look at an example with some simple math. Depending on your situation, the numbers we're using may feel like an extravagant amount, or may not feel big enough. But we're gonna go with even, easy numbers because who doesn't like easier math?

Let's say your marginal Federal tax rate is 35%, and you get a $100,000 bonus. You're going to owe $35,000 on that $100,000 bonus. But only $22,000 is going to be withheld from the bonus due to the default 22% withholding rule. That means, all things being equal, you may owe $13,000 at tax time.

NOTE: State income taxes might be an issue too, so that's worth thinking about as well. But if you live in California, you'll likely be okay. The default in California is that bonuses are withheld at 10.23%, which is actually above most people's marginal CA tax rate (which is 9.3% for most people, and up to 13.3% for the highest earners).

So let's talk through what to do about this. We'll review those 3 methods of approaching this that I mentioned before.

Method #1: The TRUE path

The idea here is that you pay the tax when you receive the income.

The way to do this is to set your regular paycheck tax withholding as you normally would, aiming to pay your full tax bill as if you didn't receive any bonuses.

Then in the "quarter" you receive a bonus, you'll make what's called an estimated tax payment to the IRS. You can do this online at the IRS website.

Let's go back to the example we used before. If your marginal tax rate is 35% and you receive a $100,000 bonus, then you know the tax withholding will be about $13,000 short. So you make a $13,000 estimated tax payment to the IRS that "quarter".

But Keith, you might be wondering, or maybe even saying out loud, why are you putting the word quarter in quotes?

Well, that's because the IRS likes to make things difficult. Not really, but yes really.

Here's how it works:

If you receive the bonus between 1/1 and 3/31, make the payment by 4/15.

If you receive the bonus between 4/1 and 5/31, make the payment by 6/15.

If you receive the bonus between 6/1 and 8/31, make the payment by 9/15.

If you receive the bonus between 9/1 and 12/31, make the payment by 1/15.

(Welcome to the real world of IRS quarters.)

This method is the truest path, in that you would pay the taxes when you receive the income.

I'd say the majority of my affected clients choose this path.

HOWEVER, if you use this method, I highly recommend speaking with your CPA about it. That's because doing this may necessitate that your CPA “annualize” your income for the year (using Form 2210) to show that the tax was paid when the income was received. That’s because tax withholding is treated as having been paid ratably throughout the year, but estimated tax payments are considered paid in the quarter they are made. Form 2210 then can “prove” that the tax was paid at the appropriate time, that is, in the quarter the income was received, thereby helping you avoid a tax penalty. See? Easy as pie (yeah right).

Method #2: The SMOOTH path

This method takes some projecting.

You start the same as Method #1 above, in that you set your regular paycheck tax withholding as you normally would, aiming to pay your full tax bill as if you didn't receive any bonuses.

Then you project how big your bonus(es) will be for the year and figure out how much short the tax withholding will be.

Then you take that amount and raise the withholding on your normal paychecks to make up the shortfall.

Clear as mud?

Let's look at an example using the same assumptions as before where you're in the 35% tax bracket and you receive a $100,000 bonus. You know you're going to owe $13,000 "extra", so you'll raise your regular paycheck withholding by that amount throughout the year. So if you receive 26 paychecks, you'd raise the withholding by $500 per paycheck ($13K divided by 26).

This path is the smoothest route because it spreads the taxes out over the entire year.

And it means you probably won't have to make any estimated tax payments or fill out that tricky Form 2210.

However, it's probably also the most difficult to calculate, because you likely don't know how much your bonuses will be over the next 12 months.

Method #3: The LUMPY path

With this path, you keep your withholding somewhat low during the year on purpose. You let your bonuses be underwithheld. It's okay, it's actually your strategy.

Then to make this method work, you need to raise your withholding on your regular paychecks dramatically towards the end of the year.

This is the lumpiest path. And maybe the scariest path.

I’ve had one client who does this and their final paychecks are literally close to $0 due to us having to have so much tax withheld.

The argument for this path is that you keep more cash on hand during the first part of the year. You stick that in an interest-bearing account, and boom, you end up earning much more interest during the course of the year.

And you should avoid a tax penalty, because tax withholding is treated as being received by the IRS ratably throughout the year, even if it all happens toward the end of the year.

The risk is that perhaps you adjust too late in the year and literally can't withhold enough from your regular paychecks to pay in as much as you owe.

The X factor

Any of these methods can and do work. Probably the trickiest part of all this is that your overall tax picture is likely much more complicated than just the income from your job.

Perhaps you have a spouse who also works. Maybe you make some money from a side gig or rental property. Perhaps you receive income and capital gains distributions from investments.

A good tax projection will incorporate all of these things, which is obviously easier said than done. If you work with a comprehensive financial planner, she or he should be able to help you with this.

So... what to do about bonuses

Enjoy them!

There are a lot of really great ways you can use the money. I've written blog posts on that before, about how to handle the uneven cash flow aspect and how to make the most of the money.

But don't forget about taxes. Make a plan beforehand so that you're not stuck with an ugly tax bill.