Clearing up a couple common tax misconceptions

By | February 7, 2015

There are many common tax misconceptions. This article attempts to clarify several big tax misunderstandings that people have:

Bonuses are taxed at the same rate as ordinary income.

It is hard to convince people that this is true, because they just take out their paystub and go “See!? You’re wrong.” However, the fact is, while your bonus check probably gets withheld at a higher rate, that check won’t be taxed differently than your other checks. There is no difference in taxes paid between someone who makes $150k/year and someone who makes $50k/year with a $100k bonus. The reason your check is withheld differently is because of the way your employer calculated how much to withhold. There are 2 ways to withhold, both of which are explained here. TLDR: Your bonus is either withheld at a flat 25% or is withheld from the table using an income of your normal monthly pay plus your bonus. The short thing to understand is, withholding will probably more than you’re used to, but any overpayment will be refunded at return time.

 

How are bonuses taxed by IRS?

For example, a lot of people say that bonuses are taxed at 40% instead of their normal 20-30%. So here’s a quick calculation using the 25% method. You’re going to have 25% withhold just for federal taxes. Then add 6.2% for Social Security (for income under,$117k), 1.45% for Medicare, and 5.75% for Virginia State Income Tax (I’m in VA). After all of these, you have seemingly paid 38.4% on your taxes! This is the number people like to use when complaining about bonus tax, but federal income tax is only part of it. And, this tax number is the smaller of the two ways to calculate bonus check withholding. If your employer used the aggregate method, your withholding will most likely be even higher! However, if your effective tax rate is below 25% (or the federal tax bracket used with the aggregate method), then you will see some of this money back when you file your return.

 

A bonus or raise to the next tax bracket almost never nets you less money.

This is a simple misunderstanding of how marginal tax brackets work. I always hear stories about getting bumped up to the next tax bracket being bad, and how they get less after tax money overall because they got bumped up a bracket. The fact is, only the extra money that puts your over the bracket line will get taxed at the higher rate.

Say you are single and make $87,800. This puts you in the 25% tax bracket, and only $50 away from the next tax bracket. Then you get a bonus of $100. $50 of your bonus will get taxed at 25%, and $50 will be taxed at 28%. The rest of your $87,800 is still taxed the same way as it would have been had you not gotten your bonus. The only way declining the bonus would be beneficial is – oh wait there is no way.

 

Taxation of Bonuses

While this is true for taxes, I do believe there are some instances of 100%+ marginal tax rates for low income earners who have certain tax credits that have an immediate phase out. For example, someone making $29,500 and contributing $2,000 to an IRA/401k etc has a tax credit of $200 available for them. Receiving a $50 bonus/raise would lose them that other $150 as they’re no longer eligible.

Another caveat here is that if you were utilizing any credits or deductions that are reduced or phased out at income thresholds, this can be more complex. Example: Friend who was close to the limit for taking a passive loss deduction on his rental; new salary put him over, he lost the whole deduction and his tax bill increased significantly – effectively erasing the impact of his raise on his cash flow.