Employers generally pay bonuses at the end of the tax year, based on their financial position shown in their year-end accounting. They distribute bonuses before they close the books, usually in a lump sum. While the exact amount is generally not known, some employers are able to give employees a rough estimate so they can begin planning their own personal tax plans. For accountants based in Pennsylvania, offering your clients tax savings strategies with bonuses is a great way to build a loyal base.
The employer can pay the bonus in the regular paycheck or give an employee a separate check. When it is a separate check, it is considered supplemental income and is taxed at a flat rate of 22%. If, however, the bonus is over $1 million, the first million is taxed at 22% and the remainder is taxed at 37%.
If it is paid in the paycheck, it is taxed at the employee’s regular tax rate. Either way, the employer automatically deducts the taxes. But your clients may be able to recoup some of that with careful planning, by either reducing gross income or increasing deductions.
How your clients can reduce gross income for the year
Your clients can apply their bonus to tax-free retirement savings, such as a 401k or traditional IRA. This should be discussed with the employer, so that it can be distributed in a way that can be deducted pre-tax, usually from the regular paycheck. This also goes for health savings accounts, which can be maximized with the help of the bonus, if the money can be carried over into future years.
If the bonus would push your client into a higher tax bracket, ask your client to discuss with the employer the option of moving the bonus to January. This is a great strategy if your client expects less income next year, and it gives you time to work with your client to plan additional deductions.
The employer might agree to a non-cash bonus instead. This might include more paid time off, a dedicated parking space, more work-from-home time, or a raise. Paid time off may have some tax implications, so look at that option closely. If the bonus is large, these suggestions would not fully compensate, but they could decrease the cash portion, thus lessening the tax effect while increasing employee satisfaction.
How your clients can reduce taxes on their bonus
Strategies exist to offset some of the taxes that have been deducted from your client’s check, essentially reimbursing some of the taxes already deducted. For those who do not itemize, there is a $300 charitable deduction ($600 when filing jointly) that can offset the bonus.
For those who do itemize, additional strategies are available to decrease taxes in a year of high income. Some of those include:
- Prepay mortgage or property taxes to increase deduction in the year of the bonus. There are some state and local tax limitations to this. For instance, property taxes that have not yet been assessed cannot be prepaid. And keep in mind that this would decrease the amount that can be itemized next year. So strategize with your client about taking the standard deduction in the following year or deciding on other deductions next year. A long-term approach to deductions would be advisable.
- Many people are extremely generous, giving significant amounts to charity. If your clients are among them or would like to consider charitable donations, these can be itemized to offset the increased income. Another option is a donor-advised fund (DAF), which allows taxpayers to donate to a fund and decide what tax-deductible charities to send it to later.
- Pay off medical expenses that are in excess of 10% of adjusted gross income.
Your clients need to understand that not only cash but also bonuses in the form of gift cards or a paid trip to a resort or a cruise are taxable. Encourage them to talk to their employers in advance of the end of the fiscal year to get an idea of how big a bonus is expected, then discuss with them their options. They will then have time to talk to their employers about how to decrease gross income and talk with you about how to reimburse some of the tax effects.
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