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Female employee gets a bonus

The satisfaction of receiving a year-end bonus may soon be tempered by the realization that income taxes will have to be paid on the extra money. Bonuses are treated as income and thus subject to taxation, but there are ways to manage and reduce the amount of taxes that will be owed. And as is the case with other income from an employer, the employer is required to withhold taxes from a bonus, reducing your take-home pay from the windfall.

Most major employers award some type of bonuses, according to a September 2020 survey of large employers by Willis Towers Watson. Next year, about two out of three big employers plan to award annual performance bonuses, and nearly that many will keep the size of the bonus pool the same as this year, according to the survey. Only about one in 10 don’t plan to give annual performance bonuses at all in 2021.

Bonus Tax Strategies

Strategies to manage the taxes you’ll have to pay on a bonus fall into two camps. First, you can reduce your gross income. Second, you can increase the deductions that apply to your income.

Make a Retirement Contribution

One of the most effective ways to reduce taxes on a bonus is to reduce your gross income with a contribution to a tax-deferred retirement account. This could be either a 401(k) or an individual retirement account (IRA). The amount you donate to the retirement account, subject to limitations, reduces your taxable income so you’ll owe less.

The limitations are different for different types of retirement accounts. They also change from year to year. For 2020, the limits are;

  • 401(k): $19,500
  • IRA: $6,000, or $7,000 for taxpayers age 50 or older.

You can’t get a deduction for a contribution to a Roth IRA.

Contribute to a Health Savings Account

If you’re covered by a high-deductible health plan, you may be eligible to make a contribution to a health savings account (HSA). These contributions reduce your gross income by the contributed amount. You can also withdraw from an HSA to pay qualified medical expenses without incurring taxes, which makes this one of the most attractive tax-management strategies.

There are limits on how much you can contribute to your HSA. For 2020, the HSA contribution limit is $3,500 for an individual and $7,000 for a family.

Defer Compensation

You may be able to save on taxes by asking your employer to delay paying the bonus until January. If the bonus would push your income into a higher tax bracket this year and you expect less income next year, this strategy makes considerable sense. Even if you will still be in the same tax bracket, you benefit by delaying the day you have to pay the taxes by a year.

Donate to Charity

Box full of donated food items

If you itemize your deductions rather than taking the standard deduction, you can make a contribution to a charity to reduce your taxable income. You may want to consider bunching donations by making two years’ worth of planned donations this year. You can donate up to 50% of your adjusted gross income to a qualifying charity, including nonprofits promoting literacy, education and amateur athletics as well as religious charities.

Pay Medical Expenses

If you itemize deductions and have medical or dental bills that weren’t reimbursed by insurance, you can reduce your taxable income by using the bonus to pay for them. You can only deduct unreimbursed medical and dental expenses if they are at least 10% of adjusted gross income.

Request a Non-Financial Bonus

You may be able to reduce taxes on your bonus to zero by asking your employer to make it a non-financial bonus. Examples of non-financial bonuses could include the ability to work from home or work flexible hours. Not all non-financial bonuses are tax-free, however. If you get extra paid vacation time in lieu of a check, for instance, it can be taxed as a financial bonus.

Supplemental Pay vs. Regular Pay

If your employer delivers the bonus to you as part of your regular paycheck, it will be taxed like regular income. If it’s delivered with a separate check, it’s taxed as supplemental income. The difference is that supplemental income is taxed at a flat 22% while regular income is taxed at your regular rate.

It is usually less costly to have the bonus delivered as supplemental income rather than as an amount added to your regular check. You may be able to get your employer to pay you so the bonus is regarded as supplemental income. However, which approach will result lower taxes depends on your individual situation.

Bottom Line

Scissors cutting a piece of paper with "TAXES" written on itYear-end bonuses are subject to taxation just like any income received from an employer. There are some strategies that can help manage or reduce the taxes owed on a year-end bonus, however. Some of these require donating to charity or making a contribution to a retirement or health savings account. Others, such as deferring compensation, will call for some coordination with your employer.

Tips on Taxes

  • If you anticipate a bonus, it’s a good idea to talk over the options for reducing taxes with an experienced financial advisor. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • Be sure you are paying what you owe in federal taxes on your income – and no more. Using a free income tax calculator can help you know for certain that you are paying the correct amount.

Photo credit: ©iStock.com/fizkes, ©iStock.com/mixetto, ©iStock.com/Soulmemoria

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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