How to Explain Holiday Bonus Tax to Your Clients

Tax Law and News talk about money

During the season of giving, many employers show their gratitude by giving year-end bonuses to their faithful employees. If some of your clients were promised a bonus or would like to offer their employees a bonus – it’s important they understand the tax implications to avoid any surprises. The most important thing to remind them of is that holiday bonuses are considered compensation, just like paychecks, and so there will be taxes withheld from the bonus—plenty of them. There may be other reductions as well.

Let’s take a look at how these withholdings work:

Social Security tax. Everyone must pay a Social Security tax on all compensation up to $127,000 of income for the year. If your clients haven’t yet exceeded that ceiling, then expect their employers to deduct 6.20 percent from the bonus for Social Security.

Medicare tax. Everyone must pay Medicare tax on all compensation, so another 1.45 percent will be deducted for Medicare tax.

Federal income tax. The IRS typically requires federal income tax of 25 percent to be withheld from supplemental income such as bonuses. Your clients’ employers have the option to aggregate bonuses with regular paychecks and withhold taxes on the whole shebang, which likely will result in even higher withholding than 25 percent. But remind them not to worry, the money may not be lost. Since tax rates on supplemental income may be higher than their actual tax rate based on their total income when filing at tax time, they may get some of it back as part of their federal tax refund when you file their taxes.

State income tax. If your state imposes an income tax, and most states do, state income tax will be withheld at whatever rate is required by state law.

Retirement plan contributions. If your clients have asked their employers to withhold a percentage of their wages as a contribution to their 401(k) or other contributory retirement plan, it is likely that same percentage will be withheld from their bonuses. So, let’s say you have requested that 15 percent of your paycheck go into retirement, then 15 percent of your bonus may go there as well. This will be good news when your clients retire with a bigger nest egg than they would have had otherwise, but it will pinch a bit in their wallets now.

Add these all together, and that’s how much may be withheld, but the good news for your clients is they are still getting a bonus! If your client has concerns about the “additional income” affecting their taxes this year, they can ask their employees to defer the bonus until after the new year.

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