If you received a holiday bonus this year, congratulations! A 2014 survey by Challenger, Gray, and Christmas, found that 78% of the surveyed companies planned to give out a year-end bonus or gift last year. About half of those planned to give traditional monetary bonuses based on company, departmental, and/or employee performance.
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Your first thoughts are probably about how you plan to spend your reward. The effect on your taxes probably does not even cross your mind. It should, because it can affect what you decide to do with any significant bonus and/or keep you from any nasty tax surprises.
Let’s start by looking at how holiday bonuses are usually taxed, starting with a straightforward extra check.
Bonuses as Supplementary Income
The IRS generally considers bonuses to be supplemental income, and they are usually taxed that way within a separate bracket. They are considered discretionary rewards that constitute a surprise to the employee.
The discretionary definition still holds even if your employer gives the same holiday bonus every year – because the employer is not obligated to give the amount (compared to a contractual performance reward or pay for overtime work).
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Bonuses usually appear on your W-2 form in a separate row labeled “supplementary income” with the appropriate withholdings shown. If not, your employer has probably chosen to classify the bonus as part of your regular wages, and it will be taxed at your nominal rate.
For most of us, the distinction does not matter much, but if you are dealing with a bonus large enough to bump you into a different tax bracket or disqualify you from deductions and/or tax credits, this point deserves extra attention.
Bonuses as Part of Wages
When the bonus is included in your wages, your employer may give you an opportunity to change your withholding for the single period that includes the bonus, allowing you to keep more of the money – or they may have incorporated extra into the amount to account for a withholding difference. Check with your HR or accounting department to see what options you may have.
Assuming you resist the urge to spend your bonus, how can you maximize its effect? The easiest way is to contribute it into your 401(k) if your employer allows this. If a portion of the reward was already diverted into the 401(k), see if you can increase the percentage – but make sure you are staying within your yearly contribution limit.
You may also be able to contribute your year-end check to other tax-beneficial accounts. Contributing to a Health Savings Account (HSA) or a Flexible Savings Account (FSA) may be able to reduce your taxable income and increase your health benefits (in the case of an FSA, make sure you will be able to spend it in sufficient time to avoid losing the benefit).
You can also consider an IRA, either traditional or Roth, as a way to maximize your holiday bonus. As with all of the above accounts, make sure you are staying within your contribution limits.
What about smaller non-cash bonuses such as Thanksgiving turkeys and Christmas baskets? They are usually considered non-taxable fringe benefits (legally known as de minimis benefits). However, if the gift is in a form that can be converted to cash such as a store gift card, it will be considered a taxable benefit. If you are not sure, check with your HR or accounting department.
Enjoy that holiday bonus, and take a few minutes to plan the best way to use it. Try to maximize your tax and savings benefits – but feel free to use a responsible amount to splurge. A bonus should wind up making you feel good!