This is an area of common confusion, and not just among the “laymen” and employees at a company, but even among the HR professionals. I have heard many folks complain how their bonus is taxed at a higher rate, and it’s barely worth anything. I have seen numerous HR e-mails about supplemental payments, such as bonuses, vacation cash-outs and similar, being taxed at a higher (40%) rate. This is simply incorrect.
What many people are confusing is the withholding rate versus the tax rate, which are quite different. Withholding is just that – an amount withheld by the employer and paid to the government, until the tax bill is settled. The tax rate is the amount we actually pay, based on the full picture, including total income, deductions and other tax considerations.
While withholding aims to match the tax rate, it is simply an advance payment toward our year-end tax liability. For employment income, it’s a rough calculation dependent on the projected yearly income and filing status (single or married, number of exemptions) as reported on the W-4 form. This simplification is why virtually everyone either owes taxes or gets a refund at the end of the year.
For supplemental payments, which are currently withheld at the higher rate of 40%, many people think that they are actually paying a higher tax rate. The reality is that IRS doesn’t really know if you got $50,000 in salary and $20,000 in bonuses or $69,000 in salary and $1,000 in bonuses. All they see on the W-2 form is that you received a total of $70,000 from your employer. You will pay the same tax on it, whatever the distribution between the base pay and supplemental payments is. Therefore, the tax rate on supplemental payments is the same as on the rest of your employment income.
One thing to note is that as your income goes up, your tax rate will increase too (all else held equal) – so effectively a bonus or a pay rise does have somewhat diminishing returns. The exact impact of course depends on your specific tax situation.