Meet Sally Jones. She is a young advertising professional that just got a big promotion.  As part of her promotion her pay structure changed.  Now she will receive a base salary plus bonus.  The bonus could be up to $50,000.  She is thrilled and is happy that things are going well.  Fast forward to April 15th and she is now confused and upset because she just got a large, unexpected tax bill.

So what happened?

We encounter this issue often during the year and the best thing you can do is understand what is going on so you can make adjustments. Sally’s base pay of $150,000 is considered regular wages and her employer withholds taxes every pay period based on her W-4 settings at work.  Based on her pay level she is in the 32% tax bracket and her bi-weekly tax withholdings are set up to deduct the correct amount of tax based on that rate. Up until there she is okay.  The problem occurs the week she receives her $50,000 bonus.  The IRS considers bonus pay a different type of pay and it is not classified as regular wages and taxes are not withheld based on her W-4 settings.  A bonus or any other type of pay (this includes stock grants/RSU’s and stock option exercises) that is not regular wages are classified as Supplemental Wages.  According to the IRS rules, Supplemental Wages have a default tax withholding rate of 22%.   Now if you recall, Sally’s tax bracket is 32%.  She is now under withheld by 10% on her bonus pay. When tax filing time comes, her income will be taxed at the 32% rate and she will be forced to pay the difference with her tax filing.

What can she do about it?

If someone is in the higher 37% bracket, this problem with the 22% rate becomes even more exacerbated. There are a few ways to deal with this:

  1. Understand the problem, make no changes and know that a large amount will be due at year end and have money saved to cover the amount.
  2. You can make a one time election for the week you receive your bonus and select Supplemental Withholding (this should be an option in your HR system) and have your employer withhold at a flat rate of 37% (Unfortunately that is the only other rate available).
  3. Estimate how much your extra tax will be and send in quarterly estimated tax payments to pay the tax during the year.

It is unfortunate that this happens very often to well intentioned and unsuspecting people, but that is how the cookie crumbles.

On top of this, the 2017 tax law changes also made changes to the manner in which wage withholding is calculated.  If your W-4 settings were Single with no dependent exemptions for example, you had the maximum tax amount withheld (not taking into account Supplemental Wages) and you generally did not owe tax at the end of the year or received a nice refund.  The nice refund received just means that you paid more during the year and had less to spend during the year.  The 2017 changes essentially did away with the dependent exemptions and set the standard withholding for a Single person to what is essentially Singe with 2 dependent exemptions.  This setting generally results in a breakeven situation at the end of the year and you will receive more in your pay each pay period.  The intention was to get more money in people’s pockets during the year but come tax time many were shocked to find out there was no refund or that they owed some tax.  Many people were not happy.

The best thing you can do is work with a tax professional who understands these nuances and meet with them prior to the end of the tax year and perform a tax projection so that you can know what is going to happen at tax time and be prepared for it.

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