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Taxes can be the Grinch that steals your bonus joy

Bonuses are considered “supplemental income,” meaning taxes could be withheld two ways.

The IRS considers a bonus

The IRS considers a bonus "supplemental income," experts say. Credit: Getty Images / iStockphoto / Jummie

You’re daydreaming about what to do with the holiday bonus you hope to get.

I hate to wake you, but there are some strings attached — taxes. Here’s how the IRS might be the Grinch that stole Christmas.

Garrett Oakley, a financial expert with Betterment, an online financial adviser, explains that bonuses are considered “supplemental income,” meaning taxes could be withheld two ways.

“With flat withholding, the IRS suggests you withhold 25 percent for federal taxes. Remember, this is withholding, not the actual amount you owe in taxes, so when you file your taxes, you could have under withheld or over withheld, depending on all other income sources and deductions,” says Oakley.

Under the aggregate method, the bonus is added to your paycheck and the total amount is used to determine the withholding amount that is based on the withholding tax tables. This could result in more funds being withheld from your bonus, compared to the 25 percent flat rate, he says.

  • What could sour a sweet bonus?

The bonus could reduce the number of itemized deductions and personal exemptions you can claim on your tax return. If your income goes above a certain amount, some of your itemized deductions can be reduced along with your personal exemptions, which could lead to a higher overall tax liability.

Your bonus could also be considered unearned income, making it subject to the 3.8 percent Net Investment Income Tax, which would be added to most types of unearned income, including capital gains, interest and dividends, Oakley said.

  • Quiet Uncle Sam

“See if your bonus would bump your total taxable income into a higher bracket for the year. If so, the amount of your income that falls within your new bracket would be taxed at a higher rate. In this situation, increase 401(k) contributions to help offset the bonus income in order to stay in the lower tax bracket,” says David Hryck, a tax lawyer at Reed Smith in Manhattan.

If you aren’t covered by an employer-sponsored plan at work, you could achieve the same result by contributing to a traditional IRA and claiming a deduction on your tax return.

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