Yes, it’s unavoidable: that cash bonus for a job well done may result in you paying a larger sum to the Internal Revenue Service (IRS).To begin, the IRS considers bonuses to be additional earnings, which means your employer must take 22% of your windfall right away. You may be able to receive part of it back when you do your taxes. However, a bonus might push you into a higher tax band, which begins at 10% for low-income taxpayers and goes all the way up to 37%.
Another word of caution, adds Rosalind Sutch, a CPA in Philadelphia with the tax consulting company Drucker & Scaccetti: “If you work in two or more states throughout the year, you may need to pay taxes on your bonus to each state.”
But don’t despair. Your tax expert may devise a few solutions that will enable you to retain as much of the additional money as the IRS permits.
- Because the IRS considers bonuses to be extra earnings, your employer is compelled to withdraw 22% of your windfall right now.
- A bonus or windfall may be a terrific way to begin your retirement savings, particularly if you’re permitted to use it to make a special contribution; it may make a lot of sense to utilize the additional money to maximize your 401(k) contribution.
- If you are paid in stock, you should consider when is the optimum moment to sell an investment that has appreciated in value in order to offset or restrict capital gains.
- If you itemize your deductions on Schedule A, you may deduct portion of your bonus by donating to charity.
- It is feasible to postpone your pay in order to reduce your taxable income for the year.
1. Set It Aside for Later
Remember, Uncle Sam sincerely wishes you a happy retirement. He encourages us all to save for retirement by contributing to qualifying retirement savings accounts, such as 401(k)s and conventional IRAs, in order to lower our taxable income. With that in mind, a bonus or windfall might be a terrific opportunity to kickstart your retirement savings, particularly if you’re permitted to make a special contribution with your bonus. That will, of course, be determined by the regulations of your plan.
It could make sense to utilize the additional money to increase your 401(k) contribution. If your employer matches your contribution, you may get an extra benefit if you meet the plan’s eligibility requirements. In 2021, the maximum amount you may contribute to your 401(k) or comparable employer retirement plan is $19,500. If you’re 50 or older, your 401(k) catch-up contribution maximum will be $6,500 in 2021. Your contribution amount increases to $20,500 in 2022, with the same $6,500 for those aged 50 and higher.
For 2021 and 2022, your total contributions to all of your conventional and Roth IRAs cannot exceed $6,000 ($7,000 if you’re 50 or older), or your taxable salary for the year, whichever is less. However, the deduction for IRA contributions is dependent to income, filing status, and whether your employer has a retirement plan in place.
Another method, according to Sutch, is to contribute to a non-deductible IRA and then convert the account to a Roth IRA as soon as possible—preferably before the end of the year. You will have to pay taxes on any gains gained due to a rise in the value of the converted IRA, but all further distributions will be tax-free. This is a crucial issue that may save you money if the Roth IRA’s assets expand, tax rates rise, or you find yourself in a higher tax bracket on the eve of retirement.
The drawback is that you’ll need to go through the paperwork with your accountant carefully to prevent making mistakes and producing taxable income, particularly if you already have an IRA. You must also meet the Roth income requirements.
You have many methods for recovering portion of the withheld bonus of 22%. For example, you may look into a deferred compensation plan at work, which allows you to stretch out both the money you earn and the tax responsibility.
If you are paid in stock, you should consider when is the optimum moment to sell an investment that has appreciated in value in order to offset or restrict capital gains. Long-term capital gains tax rates range from 0% to 15% to 20%, depending on your income level.
Any payments of yet-to-be-assessed property taxes cannot be deducted. Before using this strategy, taxpayers should consult with their accountant.
3.Pay Your Taxes
Yes, the title here seems to be a no-brainer. But let we be more specific: One advantageous use of your bonus is to “catch up” on anticipated tax payments or withholding-tax obligations, avoiding an IRS penalty for falling behind.
And that’s not all there is to it. You may be eligible to pay next year’s real-estate taxes in advance under certain conditions. It all depends on when your property taxes were calculated. If the assessment was received and paid in the current tax year, you may deduct the prepayment of property taxes for the next tax year under IRS guidelines.
4.Give It Away
If you itemize your deductions on Schedule A, you may deduct portion of your bonus by donating to charity. Most monetary donations may be deductible up to 60% of adjusted gross income. The Internal Revenue Service offers an online resource to assist taxpayers in determining the deductibility of their donations to tax-exempt organizations.
If you can’t settle on a charity, try donor-advised funds (DAFs), a mechanism for wealthy people. When you donate to a DAF, the funds are deposited into an account in your name. You may claim the entire charitable deduction in the year it was made, even if the monies are not distributed to charity until later. However, like with charitable contributions, taxpayers should ensure that contributions to the DAF are tax deductible.
5. Pay up Your Expenses
Paying impending deductible company or personal costs before December 31 is another approach to protect a bonus or windfall. Before the end of the year, you could think about updating your computer equipment or paying your home office’s power expenses. Using a credit card makes sense if you can pay off the extra debt in January.
Another option: If you have a health savings account at work, consider using a portion of your bonus or windfall to contribute up to the contribution maximum. Just make sure it’s money you can save for next year or money you know you’ll spend in the future.
The Bottom Line
As soon as you learn of a bonus or windfall, schedule a meeting with your tax expert to begin saving as much as possible. “Like many tax situations, things may become quite convoluted,” Sutch explains. “You don’t want to be whipsawed on some of the more technical laws, so now is a good moment to seek the assistance of a professional tax consultant.”
The only windfall that will not place you in that position. The amount that some may gift you tax-free in 2021 is $15,000, and it rises to $16,000 in 2022. A gift that falls within the legal limit is tax-free for both you and the sender. Such tokens may add up: For example, if all four of your grandparents donated you the maximum amount, you might get $60,000 tax-free in 2021.
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