‘Tis the season to be generous! If your clients plan on doling out year-end bonuses to their employees, there are a few payroll must-dos to keep in mind.
First, bonuses are subject to taxes. As a result, your client might need to gross up a bonus for tax purposes. And last but not least, employers must remember to report bonus amounts on Forms W-2.
So without further ado, here are the three payroll must-dos you and your clients need to know for a smooth year-end bonus process.
Payroll must-dos for year-end bonuses
Year-end bonuses are sure to make your clients’ employees happy. But done wrong (i.e., failing to withhold taxes), a bonus can land your client in serious hot water.
So make your list (done—we’ve done it for you below!) and check it twice. It’s time to find out that year-end bonus management can be quite nice.
Year-end bonuses are just the tip of the iceberg when it comes to year-end responsibilities. Here at Patriot Software, we’ve put together a year-end payroll checklist you can download for free here!
1. Calculate taxes on bonuses
Unless your client’s year-end bonus is a holiday ham, a fruit basket, or some other type of de minimis benefit, they need to withhold taxes on it. A taxable bonus includes most gift cards and other cash equivalent items.
Bonuses are subject to the same taxes as an employee’s regular wages. Employers must withhold federal income, Social Security, and Medicare taxes, along with state and local income taxes (if applicable) from bonuses.
But when it comes to withholding federal income tax from bonus payments, employers have one of two options. Why? Because a bonus is known as a type of supplemental wage.
To calculate federal income tax on supplemental pay, employers must either:
1. Withhold the supplemental tax rate of 22%
2. Add bonus amounts to regular wages and withhold taxes on the total (if paying bonus concurrently with regular wages)
Remind your clients to calculate Social Security and Medicare taxes like normal (including the additional Medicare tax on all wages over $200,000). Consult your client’s state for more information on any special state (and local) supplemental tax withholding rates.
If your client uses payroll software, calculating taxes on year-end bonuses, like tax calculations on regular wages, should be a breeze.
2. Gross-up bonuses for taxes
Employees expect their take-home wages to be a little uneven after tax withholding. Gift card amounts and cash bonuses? Not so much.
Let’s look at an example. Your client decides on a $200 year-end bonus (hooray!). But, that clean dollar amount gets a little muddy because taxes have to go and ruin everything.
Here’s why—your client needs to subtract federal income, Social Security, and Medicare taxes from the $200 gross amount:
- $200 X 0.22 (supplemental tax rate) = $44.00
- $200 X 0.0765% (employee portion of Social Security and Medicare taxes) = $15.30
- $200 - $44.00 - $15.30 = $140.70 (bonus take-home amount)
After calculating these federal taxes, the bonus turns out to be $140.70 (and that’s not even accounting for any applicable state and local taxes).
To avoid giving an employee an uneven take-home bonus, simply gross-up for taxes. A tax gross-up increases the bonus amount before taxes so that it ends up at the desired amount after taxes.
To manually gross-up a bonus amount, your client can follow these four steps:
1. Find the total tax percentage: 22% + 7.65% = 29.65%
2. Convert the percentage to a decimal: 0.2965
3. Subtract the decimal from the number one: 1 - 0.2965 = 0.7035
4. Divide the desired bonus amount by the number in Step 3: $200 / 0.7035 = $284.30 (gross pay)
Grossing up for taxes doesn’t get any easier with Patriot’s payroll software. Patriot’s new Net to Gross Payroll tool lets you gross-up for taxes in just a few short steps. Enter the amount you want the employee to take home, approve it, and voila!
3. Report bonuses on W-2
Last (but certainly not least), employers must report bonus amounts on each employee’s Form W-2, Wage and Tax Statement.
Form W-2 reports all wage and tax-related information, including employee taxable wages; income, Social Security, and Medicare taxes withheld; and benefits that impact taxes. All employers are responsible for filling out a W-2 for each employee paid during the year.
If your client is manually preparing Forms W-2, remind them to add the pre-tax bonus amount to box 1 (Wages, tips, and other compensation).
Whether your client reports the amount on a tax year 2021 Form W-2 or a tax year 2022 Form W-2 depends on which year they give the bonus to the employee.
So if your client doesn’t give the bonus to employees until January, don’t include it on a 2021 Form W-2. They’ll need to report it the following year on a 2022 Form W-2.