What happened to my bonus?
That was my first thought when I saw what was left of my first bonus check. Quite a few years have passed since then and I have learned more about how income taxes work. Having that knowledge does not make me any happier to see almost half of my bonus checks disappear, but at least now I understand how it happens.
Effective versus Marginal
It is probably a little helpful to talk about the difference between marginal and effective federal income tax rates. The marginal rates are what are always discussed in the news, whereas the effective rates are what you see in your paycheck every week. The marginal rate is what is applied to the next dollar of income that falls within that particular tax bracket. For example in 2012, if you had one dollar of income over $70,700, that dollar would incur the 25% tax rate. When you file your taxes, you are able to take exemptions and deductions before the tax rates are applied, but this gives you the basic idea. Your effective tax rate is the blending of all of the marginal rates. For example, if you had $75,000 of 2012 taxable income, then your total tax would be $9,070 and you effective rate would be 12.1%, which certainly looks better than 25%. The reason it is so much lower is that income up to $17,400 was taxed at 10% and income up to $70,700 was taxed at 15%. Only the last $4,300 of income was taxed at 25%.
The taxes we see taken out of our paychecks every week are based on an estimated effective tax rate, which is lower than the marginal tax rate. Bonus checks are different, which I learned when I saw my first one.
Bonus checks are considered supplemental wages and employers can withhold the federal tax in one of two ways, either via a flat tax rate or what is called the aggregate procedure. Every bonus check I have ever received has been done via the flat tax rate as this appears to be the easiest method from the employer’s perspective. The bonus amount is simply subjected to a 25% federal income tax rate, regardless of whether the individual has enough income to be in the 25% marginal tax bracket. What that meant for me when I received my first bonus check was that 25% went to the federal government, 5% went to my state government, 6.2% went to Social Security and 1.45% went to Medicare. It was quite a surprise to learn that 38% of my check was gone before I even got to it.
The Good News
The good news, if you can call it that, is that if your income does not fall into the 25% marginal tax bracket, then you have over paid your federal income tax due. This leaves you with two options, first would be to adjust your regular paycheck withholdings for the remainder of the year, so that less tax is withheld. The second option is to simply receive the extra funds paid in via a refund when you file your taxes the following year. Personally, I always opt for getting my money back as soon as possible. But how do I know the appropriate adjustments?
When I first began to make the adjustments, I used a handy calculator on the IRS’ website called the IRS Withholding Calculator. With it, you input various pieces of information, like your normal salary, bonus amount and taxes withheld year-to-date. If you itemize your deductions, a good estimate here would be whatever you used on the previous year’s tax return. Nowadays, I have an Excel spreadsheet that does the work for me, so I know exactly what actions I need to take.
I still get a little disappointed when I see the net amount of the check, even when the bonus was much higher. But, I am always thankful that I received a bonus check in the first place. What to do with the money that is a topic for another day.