One of the most commonly misunderstood issues that our clients face is withholding on bonus wages, equity compensation and the like. Essentially any non-salary income that is included in the recipients W2 wages. We see this all the time and there is a lot of confusion surrounding this type of earned income. “It’s taxed more than regular wages!” is a common statement we hear. Clients frequently are surprised by the amount of tax they have due particularly in a year where they receive material amounts of bonus income.
First things first: Bonus income or equity compensation in the form of RSUs or Options are TAXED exactly the same as all other earned income sources. Let me repeat that: Bonus income or equity compensation in the form of RSUs or Options are TAXED exactly the same as all other earned income sources.
What IS different about these income sources is the withholding methodology. The default withholding rate on bonus income is a FLAT 22%. That is true if you’re earning $75k or $750k. The withholding rate remains the same. Obviously this creates a problem if your marginal tax rate is higher than 22%. Essentially, if a taxpayer is in, say, the 32% bracket the withholding on that bonus is 10% “light” creating a tax gap.
Perhaps an example might help. Assume a taxpayer has perfectly dialed in their federal withholding for their normal wages. If they filed their return with just that income they would neither owe money or receive a refund. Their withholding exactly equals their calculated tax and they are pleased with that.
Now if we assume that same taxpayer is in the 32% marginal tax bracket AND they receive an unexpected $50k bonus for the year. Yay!
Their payroll department processes the bonus and they receive the net that includes 22% federal withholding (along with other taxes like FICA, Medicare, state, etc). And they figure “Great that withholding will offset the additional tax and now I can spend this money as I see fit”. Except they are in the 32% bracket but the withholding was only 22%. That means the withholding was 10% light and there is a $5k tax trap coming their way ($50k times 10% rate shortfall)!
If the bonus is even greater than $50k it’s easy to see this situation getting pretty expensive pretty quickly. To say nothing of this additional bonus income potentially pushing people into higher tax brackets. We see this happen dozens of times per year with our clients. Of course, the IRS gets their money either via withholding or when you file your return. To some extent it’s pay now or pay later.
Unfortunately, this scenario is often a complete and utter surprise to taxpayers. Are there strategies that we can employ to lessen the tax impact of these bonuses? Perhaps. And if there are available strategies we need to know about this income BEFORE THE END OF THE YEAR. Once it’s 2024 and 2023 W2s are issued, not much can be done from a planning perspective.
But even if there aren’t tax reduction strategies available to a taxpayer, we can at least quantify the tax impact and what type of tax bill is coming. Knowing what taxes will be due in 4 or 5 months is certainly preferable to being completely shocked on April 1!
Please contact our office if you have received a material bonus or equity compensation in 2023. We can’t help you plan for the associated taxes if we don’t know about it until we prepare the return.