Bonuses, whether they’re a year-end holiday tradition or an incentive system, aren’t tax-free money. They’re income -- and in the eyes of the Internal Revenue Service they must be treated as such. Whether your employer withholds taxes when you receive your bonus or provides you with a lump-sum amount that’s reported to the IRS, you can expect the take-home amount to be reduced by Uncle Sam.
If your employer gives you a bonus and chooses to withhold payroll taxes from it, it may be taxed at a higher rate than normal income and, if withholdings are quickly calculated, withheld at a rate higher than necessary. A large bonus may push an employee’s earnings into a higher tax bracket for the month, and the amount of the bonus is taxed at the next rate in the graduated income tax brackets. Because these brackets are calculated to annualize withholding as if taxpayers consistently earn that amount every month, a one-month spike in income may be taxed in a bracket that calculates withholdings at a higher income level. For example, if your monthly salary is $4,000 and you received a $3,000 bonus, you'll be taxed as if you earn $7,000 a month, or $84,000 a year. This method withholds more from the bonus than necessary, though the surplus is returned to the employee as an income tax refund.
Other employers may simplify their bookkeeping by providing employees with a lump-sum bonus and reporting the amount to the IRS on a 1099-MISC form. When preparing tax returns, employees receive a copy of the 1099 and must declare it as income at the end of the year. In this situation, if payroll tax surpluses do not cover the tax liability for the bonus, the employee must pay the balance when filing taxes. Employers are not required to submit a 1099 if an employee’s bonus was less than $600, though employees still must claim the income at the end of the year.
Cash bonuses also are income subject to withholding. The value of any cash bonuses, prizes or compensatory gifts given to an employee during the year must be claimed on line 21 of the employee’s 1040 as “Other Income.” It is a federal crime to receive payment in the form of cash bonuses and not report it as income on your taxes at the end of the year.