Variable bonus compensation: What is it? How is it taxed? And what should you do with it once it’s yours?

By Amber Miller, CFP®, CSRIC™

What is a bonus? – a bonus is an additional paycheck that is a (often large) lump sum amount. They are typically handed out once (sometimes twice or quarterly) per year and often right at the end of your company’s fiscal year. Your bonus amount may be based on your role, your performance, or a set percentage.  You should know this ahead of time, but every once in a while, bonuses are complete surprises.  Congratulations! So, what’s the bad news?  The high level is that any bonus is just like your regular paycheck – it is income. And income is taxed by the IRS. This means, that you owe taxes on your bonus.

Most often you will get your bonus either as a separate paycheck or it will be integrated into your current paycheck as a second line-item; so most often your employer will automatically withhold taxes for you like they do your regular paycheck.

Depending on if you receive a separate or combined paycheck for your bonus will determine how your bonus is taxed. If you receive a separate paycheck, you will have an automatic, flat 22% withheld on your bonus (if your bonus is over $1MM this increases to a flat 37%). This flat withholding is actually used on all other sorts of supplemental income like commissions, severance pay, back pay, vacation pay, moving costs, overtime and other taxable benefits.

Instead, if you receive your bonus as part of your “regular” paycheck, then the taxes withheld tend to be higher than 22%. This is because on a combined paycheck, your employer refers to your requested withholding on your w-4 and applies that to the (now) larger sum, so as a percentage this is almost always a higher amount.

Either way, if you pay more now in taxes, you will be eligible to reclaim that when you file your taxes in April. But for some this can be a long time to wait. **Remember, the opposite can also be true – if you do not withhold enough in your paychecks and bonus payments, then you can owe in April.
Not always. You can ask your employer if they would give you separate paychecks, which would at least put you in the flat percentage option. You could also ask if they would delay the bonus payment until the following year. This helps if you know you are in a higher tax bracket this year than you will be next year – maybe you will work less next year, or you are buying a house, or plan on increasing your charitable contributions.
What should you do with your variable bonus?  So, you have your bonus, minus all the withheld taxes, what should you do with it?  If you have practiced good cash-flow planning with your financial planner, then you should not “need” this bonus to pay for things like household bills and expenses. I recommend clients plan for bonuses, but to not expect them – especially since the final amount can often vary depending on things that are out of your control, like overall company performance that year. This way, the bonus is really an extra. I work with my clients to strategize things like paying down debt, or filling up their emergency savings account, or putting it aside for future car replacement, or kitchen remodels – the big things.  If all of these have been accounted for with proper planning already, then the bonus can be invested. In fact, you can often select to have a portion of your bonus added to your employer retirement plan (401k, 403b, 457, etc).  This may be a separate selection and you will want to check with your HR department on these details (your financial planner can also help.)

If you have maxed out your retirement contributions at work for the year, then your bonus is a great way to build your Roth IRA either through a direct contribution, or the back-door non-deductible IRA to Roth conversion. If you have now also maxed your IRA contributions, then consider a brokerage investment account.

If you are charitably inclined, you can also lower your taxable income by increasing your charitable contributions. In 2020 the tax law changed to allow all taxpayers up to a $300 deduction for charitable contributions even if they do not itemize deductions.  If you itemize, you can deduct even more.

Can I put more than the annual limit into my retirement account with money from my bonus?  No. The annual contribution limit to contribute into your employer retirement account (401k, 403b, 457, SEP, etc) remains the same. If you are on track to contribute the maximum this year, then contributing “extra” from your bonus will only get you to that maximum faster. You cannot put more than the annual limit into any of these accounts – and your HR department knows this and typically “turns off” your contributions once they hit the limit. Obviously, there are a lot of moving parts around your bonus: when will you get it? how will it be taxed? what can you do with it? what should you do with it? A bonus is a taxable event, but it is most importantly something to plan properly for, so that it does not get sucked up into your lifestyle spending, and instead is used for your life goals.  Well, okay, maybe enjoy a nice dinner out or a movie to celebrate…but let’s plan for the rest of it. Schedule a call with me and together, we’ll make a plan that works for you.

We have received a lot of questions from contract workers (1099s) about how their bonuses are taxed. Here are two additions to our original article:

What if I’m a contract worker and don’t get my taxes automatically withheld from my paychecks?  If you are a contract worker, then you are probably already familiar with paying estimated quarterly taxes and saving up for your tax bill on your own. This will be no different if you receive a bonus. In fact, if you do not have taxes withheld from your paycheck, you will owe your taxes by the next quarterly deadline, or else you will face stiff penalties.  I recommend you work with your financial planner and tax professional on these details to avoid any penalties and to help regulate your income stream throughout the year.


Amber Miller, CFP®, CSRIC™, is a Sr. Financial Planner in the Twin Cities office of The Planning Center, a fee-only financial planning and wealth management firm. Email her at amber@theplanningcenter.com.