Bonuses and Taxes:

Full Transcript:

I just got my bonus. Wait, why is it taxed so high?

First, let’s start with a highly simplified explanation of US federal income tax. Note we’re only talking about income tax. In addition to this, you have to pay Social Security, Medicare, and any state and local taxes. The US federal income tax system is a progressive tax system. That means that the more money you make, the higher rate you’re taxed at. You’ll see that in the US, tax brackets start at 10%, and they currently go up to 37%. To understand how much you owe in tax, you first need to understand what your taxable income is. Let’s walk through that equation.

First, you start with your income, and then you subtract out any adjustments. Adjustments are things like your pre-tax 401k contributions and any HSA or FSA contributions. From there, you get your adjusted gross income. Next, you’re going to subtract deductions. You can either itemize deductions or take the standardized deduction. Itemized deductions include the sum of your mortgage interest, charitable donations, and any state and local taxes. Whichever one of those is higher is what you subtract from your AGI, and that gives you your taxable income. You then apply the tax brackets to your taxable income to get your total tax. Simple.

All right, it’s not that simple, so let’s walk through an example. Let’s assume that your total income is $260,000, $200,000 base salary, and a $60,000 bonus. Let’s also assume that you’re married filing jointly, and this is your only household income. Now, if you maxed out your pre-tax 401k for this year, you would then have an adjustment of $22,500. That leads you to an AGI of $237,500. Next, you’re going to subtract out your deductions. In this case, let’s assume that your itemized deductions are less than the standardized deduction. The 2023 standardized auction for a married filing jointly couple is $27,700. So when we subtract that from your AGI, you get a total taxable income of $209,800.

Now we’re going to apply the tax brackets to that to get total tax. So the first $22,000 is taxed at 10%. The next $77,000 is taxed at 12%. The next $100,000 is taxed at 22%. And the remaining $20,000 is taxed at 24%. When you sum all of that up, you get a total tax of $37,152.

So because your taxable income is at $209,000 or above the $190,000, you’re in the 24% marginal tax bracket. However, when you look at your actual effective tax rate, that is how much you paid in taxes divided by your taxable income. You’ll see that your effective tax rate is just about 18%.

All right. So now that we know how taxes work, let’s talk about your bonus. Throughout the year, Shell or your employer withholds money based on what they think your total tax is going to be. This is an estimation. Your salary, they estimate, in this case, $200,000 will put you in the 22% to 24% tax bracket. However, when you get a lump sum like your bonus, they may estimate that you’ll be in a higher tax bracket. So, therefore, they withhold a higher rate.

Now, like I said, the withholding is an estimate, and when you file taxes in the spring, it’s a reconciliation. And if that estimate is too high, you get that money back in the form of a tax refund. Now, if that estimation is too low, then you owe money. You really want your withholding to be pretty close to your taxable income. Otherwise, you are giving the government an interest-free loan. Or if you’re under-withheld, you will pay a penalty. Now to adjust your withholding, go to your W-4 form within your HR system and increase or decrease withholding as needed.