How Are Bonuses Taxed? Withholding Rules for Employers
Bonuses are withheld at a flat 22 percent or by the aggregate method. What that costs you, the overtime recalculation, and why 22 percent is not the tax.
How Are Bonuses Taxed?
The two withholding methods and which one to use, why the 22 percent everyone quotes is not a tax rate, what a bonus actually costs the business once payroll taxes are added, and the overtime recalculation on nondiscretionary bonuses that quietly creates back-pay liability at small companies
Every bonus payment I have ever run has produced the same message from at least one person: why did they take so much. The answer is short, it is reassuring, and almost nobody hears it before payday because nobody thinks to say it.
That part is a communication problem with a one-sentence fix. The part that actually costs money sits on your side of the ledger and does not appear in any of the consumer articles about bonus taxation: if the bonus was nondiscretionary and went to non-exempt employees who worked overtime, you owe them more overtime than you already paid.
This covers the two withholding methods and which to use, why the 22 percent everybody quotes is not a tax rate, what a bonus really costs the business, and the overtime recalculation. I build the people and records tooling for businesses without an HR department at FirstHR, and FirstHR is an onboarding and HR platform rather than a payroll provider. This is general information, not tax advice.
The Short Answer
Bonuses are taxed as ordinary income, exactly like salary. There is no separate bonus tax and no penalty rate. What differs is how much is withheld at the moment of payment, and federal rules give employers two ways to calculate that.
Everything downstream of that definition follows from one distinction the employee never sees: whether the payment was identified separately or blended into a normal paycheck. That choice decides which method is available to you.
22 Percent Is Not a Tax Rate
This is the single most useful thing an employer can explain, and it takes one sentence. The flat 22 percent is a withholding rate: an estimate collected at the time of payment, reconciled on the employee's annual return like every other dollar withheld all year.
| Employee’s marginal rate | Withheld at the flat rate | What happens at filing |
|---|---|---|
| 12 percent | 22 percent | Too much was withheld; the difference comes back as refund |
| 22 percent | 22 percent | Roughly correct |
| 24 percent | 22 percent | Slightly under-withheld; a small amount may be owed |
| 32 percent or above | 22 percent | Materially under-withheld; the employee may owe at filing |
Both directions produce complaints and they are opposite complaints. Lower-paid employees feel robbed on payday and are made whole months later. Higher-paid employees feel fine on payday and are surprised in April. Saying which of these applies, before the money lands, is the whole of the fix.
The Two Methods
Federal rules give employers a choice, and the choice changes the employee's net payment without changing their annual liability (IRS Publication 15).
The flat rate is only available where the supplemental payment is identified separately from regular wages. Paying a bonus by adding it to a normal paycheck line removes the option, which is a mechanical reason to run bonuses as their own payment rather than folding them in (26 CFR 31.3402(g)-1).
Which One to Use
For a small business the percentage method wins on almost every dimension that matters.
| Consideration | Percentage method | Aggregate method |
|---|---|---|
| Ease of calculation | One multiplication | Depends on the last paycheck and the withholding tables |
| Predictability for the employee | High, and checkable | Low, and varies by pay period |
| Typical net to the employee | Higher | Often lower, sometimes substantially |
| Accuracy for a high earner | Under-withholds | Closer to the real liability |
| Questions generated | One, answered in a sentence | Several, and harder to answer |
| Requires separate payment | Yes | No |
The one genuine argument for the aggregate method is the fourth row: for a highly paid employee, flat withholding at 22 percent can leave a real bill in April. Where you know that is the case, the kinder move is usually to keep the flat method and tell the person plainly that they may want to set some aside, rather than to withhold more and explain why their bonus shrank.
Above One Million
Where an employee's supplemental wages exceed $1 million within a calendar year, the excess is subject to mandatory withholding at 37 percent. This is not optional and the aggregate method is not available for the portion above the threshold.
Two details catch employers who assume this only affects large companies. The threshold is cumulative across the year rather than per payment, so several smaller supplemental payments can reach it in combination. And it counts all supplemental wages, not only bonuses, which brings severance, commissions, and separately paid overtime into the same total (26 U.S.C. 3402).
Payroll Taxes Still Apply
Withholding rates get all the attention and the employer cost sits underneath them. A bonus is wages, which means the whole payroll tax stack applies.
The second cost is the one that makes timing matter. Unemployment tax wage bases are annual, so a bonus paid in January to somebody who has not yet crossed them attracts tax that the same bonus paid in December would not. It is not usually decisive, and it is worth knowing before setting a bonus date by habit.
The Overtime Recalculation
This is the part that turns a bonus into a wage claim, and it applies to non-exempt employees only. A nondiscretionary bonus must be included in the regular rate used to calculate overtime for the period the bonus covers, which means the overtime you already paid was calculated on too low a rate.
The correction is mechanical. Apportion the bonus across the weeks it covers, add it to the earnings for each of those weeks, recompute the regular rate, and pay the additional half-time premium on the overtime hours already worked. It is arithmetic rather than judgment, and payroll systems handle it when they are told the bonus is nondiscretionary.
What makes it dangerous is silence. An employer who pays a quarterly production bonus to hourly staff, never recalculates, and does this for three years has accumulated a back-pay exposure across everybody who worked overtime in that period. Nobody notices until somebody does.
State Withholding
Federal withholding is only half the calculation. Many states apply their own flat supplemental rate to bonuses, others require the standard withholding tables, and a handful have no income tax at all.
The practical consequence is for anybody with employees in more than one state. A single company-wide supplemental rate will be wrong for some people, and the direction of the error varies, which means it is not even consistently generous or consistently stingy. This is one of the specific reasons multi-state payroll is harder than it looks.
Local taxes add a third layer in some jurisdictions. Where you have people in cities with their own income taxes, confirm the supplemental treatment there too rather than assuming it follows the state rule.
Grossing Up
Sometimes the point of a bonus is that somebody receives a specific round number. Grossing up means calculating backwards from the net to the gross, so the withholding comes out of a larger figure and the employee ends up with the intended amount.
The thing to note before deciding is simply the size of the multiplier, because a $1,000 net payment costs considerably more than $1,000 and approvals are frequently given against the net figure.
Timing and Year End
December bonuses are a habit rather than a rule, and the timing has consequences on both sides worth a moment's thought.
For the employee, the payment falls into the tax year they receive it, which matters at the edge of a bracket and rarely elsewhere. Deferring a payment to shift somebody's tax year is possible in principle and carries constructive receipt questions that make it a conversation with an accountant rather than a scheduling decision.
For the employer, January restarts the unemployment tax wage bases, so the same bonus frequently costs more in January than in December. Deductibility timing also depends on your accounting method and, for accrual taxpayers, on when the obligation became fixed. None of that should override the business reason for the timing, and all of it is worth knowing before the date gets set by tradition (IRS Topic 401).
Where Small Employers Get This Wrong
Five patterns, and the first one is the only one that becomes a legal liability.
Not recalculating overtime after a nondiscretionary bonus is first, largest, and almost universal at small companies. It accumulates quietly across every overtime hour in every bonus period.
Calling a bonus discretionary because you decided the amount is second. Discretion over the amount is not the test; whether it was promised or formula-driven is.
Blending the bonus into a regular paycheck is third. It removes the flat rate option, forces aggregate withholding, and usually reduces the net the employee receives.
Not explaining the withholding rate beforehand is fourth. It is a one-sentence prevention for the entire category of complaint that follows every bonus run.
And budgeting the bonus without the employer taxes is last. A bonus pool approved at its gross figure is short by the payroll tax stack before anybody has considered the overtime true-up, and that gap is found at the worst possible moment, which is after the announcement.
Frequently Asked Questions
How are bonuses taxed?
A bonus is ordinary taxable wages. What differs is withholding, not taxation. Federal rules treat a bonus as supplemental wages, and an employer may withhold using either the percentage method, a flat 22 percent for amounts up to $1 million in a year and 37 percent above that, or the aggregate method, which combines the bonus with the most recent regular pay and calculates withholding on the total. Social Security and Medicare apply as they do to any wages. The employee’s actual tax on the bonus is settled on their annual return, whichever method was used.
Why was 22 percent withheld from my employee’s bonus?
Because you or your payroll provider used the percentage method for supplemental wages, which applies a flat 22 percent federal withholding rate to bonuses up to $1 million. It is a withholding rate rather than a tax rate. An employee whose marginal rate is 12 percent has had too much withheld and will get it back at filing; one whose marginal rate is 32 percent has had too little withheld and may owe. Saying this in one sentence before payday prevents most of the questions that otherwise follow.
Which withholding method should an employer use?
For most small businesses the percentage method is the better choice. It is simple, predictable, easy to explain, and an employee can check it themselves. The aggregate method typically withholds more, because combining the bonus with a regular paycheck pushes the total into higher bracket territory for that period, which produces both a smaller net payment and more questions. Neither method changes the employee’s eventual liability. The flat rate does require the bonus to be identified separately from regular wages rather than blended into a normal paycheck.
Do bonuses have Social Security and Medicare taken out?
Yes. A bonus is wages, so Social Security and Medicare apply exactly as they do to regular pay, at 6.2 percent and 1.45 percent each for employee and employer, with Social Security limited by the annual wage base and Medicare uncapped. The additional Medicare tax applies to the employee above the relevant threshold. Federal and state unemployment taxes also apply where the employee has not yet reached those wage bases, which is why a bonus paid early in the year costs an employer more than the same bonus paid in December.
Does a bonus affect overtime pay?
A nondiscretionary bonus does, and this is the most expensive thing on this page. Bonuses that were promised, announced in advance, or tied to a formula such as production, attendance, or hitting a target must be included in the regular rate used to calculate overtime for the period they cover. That means going back over the bonus period, recalculating the regular rate with the bonus apportioned in, and paying the additional overtime premium owed. A genuinely discretionary bonus, decided entirely by the employer after the fact with nothing promised, is excluded.
How much does a bonus actually cost the employer?
More than the bonus. On top of the gross amount, the employer owes 7.65 percent for its share of Social Security and Medicare, subject to the Social Security wage base, plus federal and state unemployment taxes where the employee has not reached those wage bases. If the bonus is nondiscretionary and goes to non-exempt employees who worked overtime during the period, add the overtime recalculation. A $5,000 bonus is roughly $5,383 before unemployment taxes and before any overtime true-up.
What does grossing up a bonus mean?
Grossing up means paying a larger gross bonus so the employee receives a specific net amount after withholding. If you want somebody to receive $1,000 in hand, you calculate backwards from the applicable withholding rates and pay a gross figure high enough that the net lands on the target. It costs meaningfully more than the headline number, and it works cleanly only where the withholding rate is predictable, which is another argument for the flat percentage method. Employers usually use it for recognition awards where an odd net figure would undercut the gesture.
Is it better to pay a bonus in December or January?
For the employee, it shifts which tax year the income falls in, which matters more at the edges of brackets than in the middle. For the employer, a January payment restarts the unemployment tax wage bases, so a bonus paid in January frequently carries more employer tax than the same bonus in December, when many employees have already crossed those bases. Deductibility timing also differs depending on your accounting method. None of this should override the business reason for the timing, but it is worth knowing before deciding.