Understanding Withholdings: The Anatomy of a Bonus Payment
For many people, withholdings on paychecks are the number one thing getting in the way of them spending their hard-earned money. There is no better example of this than a discretionary bonus payment. These bonuses are often withheld at the marginal tax rate of the payee, which makes the total dollar withholdings larger than one might expect. Today, we are going to explore the anatomy of a bonus payment and examine the difference between the stated bonus amount and what is taken home.
For the sake of this example let's take a look at a $10,000 bonus payment:
Let's break down each of the withholdings:
Federal Income Taxes (22%)
This is by far the biggest and most surprising withholding for most people. Federal taxes should not come as a surprise by themselves, but having an amount withheld at a different rate is something not a lot of people are used to. Bonuses are considered supplemental wages by the IRS and are therefore subject to a standard withholding rate to simplify the process for employers. In 2020, this standard withholding rate is 22%. It’s important to remember that bonuses are considered ordinary income and the true amount taxed is going to depend on your marginal tax rate.
People are generally used to the standard withholdings rate which incorporates a weighted average of their gradual tax rates (between 10% and up to 37%) as opposed to the flat rate used in the example. For most of you reading this, the amount that comes out of your paycheck is likely to be less than the 22% used here, which explains the surprise people experience when getting a bonus payment.
Social Security (6.2%) and Medicare (1.45%) (FICA) Taxes
Social Security Taxes (6.2%) - These taxes are paid by all employees up to an annual limit. Once an employee reaches a certain amount of taxable earnings during the year ($137,700 in 2020), the employee will no longer be required to pay this tax.
Medicare Taxes (1.45%) - Unlike Social Security, Medicare Taxes are imposed on all earnings.
State and Local Taxes (8.95%)
State Taxes (5.75%) - Most states have some sort of income tax for income earned in that state. In this example, the state used is Maryland, which has a 2%-5.75% tax rate depending on the amount of income earned. For the same reason as federal taxes, many states have state taxes withheld at a standard rate to make things easier for employers. Other states will have different withholding rates and methods, so be sure to check your state’s methods.
Local (County) Taxes (3.2%) - Counties also often have a flat tax rate to support local programs and public schools. The withholding of these amounts on bonus checks will vary from state to state, but in Maryland, these are included as a part of the withholding. Although this tends to be one of the smallest percentages taken, it adds up with the other taxes taken.
Other Withholdings (6%)
Retirement Plan (6%) - Employers can offer to withhold more or less retirement contribution amounts from bonuses at the request of the employee. If no such request is made, the employer will usually default to the standard amount taken out for retirement as if the bonus was any other paycheck. In this example, the employee is withholding 6% of the total gross pay to obtain an employer match.
We started with $10,000 and ended up with a payment of $5,540. Even though $600 of that difference went towards retirement, the remaining $3,860 went towards paying taxes! Depending on your personal scenario the number could be higher or lower depending on your state and tax bracket. No one likes paying taxes (myself included) but seeing everything laid out in front of me really gave me some perspective of where half of my bonus checks end up going. With this knowledge in hand, I hope you can better understand your next bonus check and can plan you spending and saving strategy accordingly.