Year-End Bonuses: Tax Implications & Payroll Best Practices
When the year comes to a close, many businesses reward their employees with year-end bonuses as a token of appreciation for their hard work. These bonuses can boost morale, improve retention, and incentivize strong performance. But are you aware that bonuses are taxable income? Employers must distribute end-of-year bonuses properly to ensure compliance with tax laws and payroll regulations.
Don’t be caught unaware—issuing bonuses outside of payroll, such as giving cash, checks, or gift cards, can lead to costly tax issues. As we mentioned in our prior article, “9 Payroll Management Areas Not to Overlook,” it’s up to the employer to correctly identify, classify, and withhold taxes on taxable benefits. In other words, ignorance is not a valid excuse for errors.
Here’s what you need to know about how bonuses are taxed, the different types of bonuses, and payroll best practices for accurate reporting and processing.
Types of Year-End Bonuses
Employers may offer different types of year-end bonuses, the most common of which are listed below.
Performance bonuses are rewarded to employees based on individual or company performance.
Holiday bonuses are a fixed amount given during the holiday season as a goodwill gesture.
Retention bonuses are distributed to encourage employees to stay with the company.
Profit-sharing bonuses are based on company profits and are typically distributed annually.
Discretionary vs. Non-Discretionary Bonuses: Discretionary bonuses are unexpected and not promised in advance, while non-discretionary bonuses are planned and may impact overtime calculations.
How Bonuses Are Taxed
The IRS considers bonuses supplemental wages and requires them to be reported and taxed accordingly. In addition to federal tax withholding, employers must also deduct Social Security and Medicare taxes (FICA taxes) from bonuses, and depending on the state, they may also need to withhold state income taxes.
For 2025, the bonus tax rate varies depending on the method used:
Aggregate Method: The bonus is added to an employee’s regular paycheck and taxed at the employee’s standard income tax rate.
Percentage Method: A flat bonus tax rate of 22% is applied to the bonus amount (for amounts under $1 million). If the bonus exceeds $1 million, the portion above that threshold is taxed at 37%.
Employers who do not adequately account for tax withholding could face penalties and compliance issues. It is essential to process year-end bonuses correctly through payroll to avoid costly tax mistakes.
Payroll Best Practices for Year-End Bonuses
Businesses should follow these payroll best practices when handling end-of-year bonuses to ensure compliance and avoid tax surprises.
Process Bonuses Through Payroll
One of the most crucial steps in accounting for bonuses is ensuring they go through the payroll system. Simply writing a check or giving out cash without withholding taxes can lead to significant tax liabilities for both the employer and the employee.
Communicate Tax Implications To Employees
Employees may not realize that their bonus will be subject to withholding. Clearly explain how the bonus tax rate applies and provide an estimate of their take-home amount to avoid confusion.
Decide On The Tax Withholding Method
Choose whether to apply the aggregate method (taxing at the employee’s regular rate) or the percentage method (a flat 22% tax rate when the bonus is paid as a separate check). This is where an outsourced accounting partner like JLS Accounting can be helpful in determining the best approach.
Consider Grossing Up Bonuses
Some employers choose to “gross up” a bonus, meaning they cover the taxes by adding that amount to the gross amount so the employee receives the full intended amount. This approach requires careful calculations to ensure accurate tax withholding.
Plan for Payroll Processing Deadlines
The timing of payroll bonus payments could impact W-2 reporting and employee tax filings. As the employer, you might defer year-end bonuses until the new year (for potential tax benefits if you expect higher revenue in the next year).
Keep Accurate Records
Maintain detailed records of all bonuses issued, including amounts, tax withholdings, and payment dates. Proper accounting for bonuses ensures compliance with IRS regulations and facilitates year-end financial reporting.
Final Thoughts
Year-end bonuses can be a fantastic way to reward employees, but they come with important payroll and tax responsibilities. Employers must ensure all bonuses go through payroll, with proper withholding and reporting, to avoid compliance issues. By understanding how bonuses are taxed, implementing payroll best practices, and maintaining accurate records, businesses can provide bonuses smoothly while staying in compliance with tax laws.
For further guidance, book a consultation with JLS Accounting. We can help ensure your business handles end-of-year bonuses correctly and efficiently.