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Use Your Bonus Wisely to Catch a Tax Break

Jun. 17, 2015 Betterment

Bonuses are tricky. Part windfall, part tax event, part savings opportunity—you need to juggle multiple aims and concerns to maximize your yearly (or quarterly) perk.

Tax time is coming, so keep reading as it’s still possible to contribute to a traditional or Roth IRA for 2013—yes, even if you also participate in your company’s 401k. Betterment’s efficient IRA set-up can help you get there quickly and securely, so you get the added tax break.

Bonuses are considered “supplemental income” by the IRS, which means they could be withheld on differently than your regular salary. Bear in mind that Betterment is not a tax advisor, nor should this article be considered tax advice. Please consult your tax professional if you need tax advice.

The IRS suggests a flat withholding of 25% from bonuses, and many employers follow that method. (Remember that withholdings are meant to be an estimate of how much you’ll owe at the end of the year, not the actual tax itself.) But some employers use the aggregate method, in which your whole bonus is added to your regular paycheck, and the combined amount is withheld at the normal income rate, as though that amount is representative of what you make every paycheck, which could be higher (or lower) than 25%.

Some people believe that bonuses are taxed at a higher rate than ordinary wages, but that’s not the case. The aggregate method of withholding can result in bumping you into a higher estimated tax bracket, which creates the illusion that you “keep less of it,” but no special tax rates apply just because a payment from your employer is characterized as a bonus. So a bonus is like a raise, but when your income goes up, it could do more that just move you to a higher tax bracket—you could potentially lose certain deductions and tax credits.

Click below to find out how you can use tax-deferred or even taxable accounts to preserve and grow your windfall.

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