5 Tax Strategies for a Bonus or Windfall

Yes, it's inevitable: That cash bonus for a job well done can result in you paying a more significant chunk of money to the Internal Revenue Service (IRS). To start, the IRS considers bonuses to be supplemental wages, which means your employer is required to immediately withhold 22% of your windfall. You could get some of that back at tax time. But then again, a bonus might bump you into a higher tax bracket, which starts at 10% for low-income taxpayers and tops out at 37%.

Heed another precaution, says Rosalind Sutch, a Philadelphia certified public accountant (CPA) at the tax consulting firm Drucker & Scaccetti: "If you work in two or more states during the year, you might need to pay taxes on your bonus to each state."

But take heart. Your tax advisor can map out a few strategies to let you keep as much of that extra cash as the IRS allows.

Key Takeaways

  • The IRS considers bonuses to be supplemental wages, which means your employer is required to immediately withhold 22% of your windfall.
  • A bonus or windfall can represent a great way to jumpstart your retirement savings, especially if you’re allowed to use your bonus to make a special contribution; it might make very good sense to use the extra cash to maximize your 401(k) contribution.
  • If you are paid in shares of stock, you’ll want to mull over the best time to cash out of a security that has increased in value—in order to offset or limit capital gains.
  • If you itemize your deductions on Schedule A, you can shield some of your bonus by making a charitable donation to charity.
  • It is possible to delay your compensation in order to cut back on your reportable income for the year.

1. Set It Aside for Later

Remember, Uncle Sam truly wants you to have a great retirement. He's encouraging us all to build up our nest eggs by using contributions to qualified retirement savings accounts, such as 401(k)s and traditional IRAs, to reduce taxable income. With that in mind, a bonus or windfall can represent a great way to jumpstart your retirement savings, especially if you're allowed to use your bonus to make a special contribution. That, of course, will depend on your plan's rules.

401(k)s

It might make very good sense to use the extra cash to maximize your 401(k) contribution. This move may even reap an additional reward if your employer kicks in a matching sum—provided you qualify under plan guidelines. The amount you can contribute to your 401(k) or similar workplace retirement plan is $19,500 in 2021. The 401(k) catch-up contribution limit—if you're 50 or older—will be $6,500 in 2021. In 2022, your contribution amount goes up to $20,500, with the same $6,500 for those age 50 or older.

IRAs

For 2021 and 2022, your total contributions to all of your traditional and Roth IRAs cannot be more than $6,000 ($7,000 if you're age 50 or older), or your taxable compensation for the year, if your compensation was less than this dollar limit. The deduction you can take on IRA contributions, however, is subject to limits based on your income, filing status, and whether your employer has a retirement plan in place.

Roth IRA

Another strategy, says Sutch, is to make a contribution to a non-deductible IRA, then convert the account to a Roth IRA as quickly as possible—at very least before the end of the year. You will need to pay taxes on any gains made because of an increase in the value of the converted IRA, but distributions you take later will be tax-free. That's an important consideration that can save you money if the assets of the Roth IRA increase, tax rates increase, or you end up in a higher bracket on the eve of your retirement.

The caveat is that you'll need to walk through the paperwork carefully with your accountant to avoid tripping up and generating taxable income, especially if you already have an IRA. Also, you'll need to fit the Roth income limitations.

2. Defer Compensation

When it comes to getting back some of that 22% withheld bonus, you have a number of options. For one, you might look into a deferred compensation plan at work, which will allow you to spread out both the money you pocket and the tax liability.

If you are paid in shares of stock, you’ll want to mull over the best time to cash out of a security that has increased in value—in order to offset or limit capital gains. Long-term capital gains rates are 0%, 15%, and 20%, depending on your income level.

Any prepayment of property taxes that have yet to be assessed cannot be deducted. Taxpayers are advised to check with their accountant before trying this tack.

3. Pay Your Taxes

Yes, the heading here sounds like a no-brainer. But let’s be a bit more specific: One beneficial way to use your bonus is to “catch up” on estimated tax payments or your withholding-tax obligations and thereby sidestep an IRS penalty for coming up short.

And that’s not all you can do. Under certain circumstances, you might be able to pay next year’s real-estate taxes in advance. It all depends on when your real estate taxes were assessed. Under IRS rules, you can deduct the prepayment of property taxes for the next tax year if the assessment was received and paid in the current tax year.

4. Give It Away

If you itemize your deductions on Schedule A, you can shield some of your bonus by making a charitable donation to charity. For most cash contributions, up to 60% of adjusted gross income can be deducted. The IRS maintains an online resource to help taxpayers determine the deductibility of their contributions to tax-exempt organizations.

If you cannot decide on a charity, you might consider donor-advised funds (DAFs), a tool for high-net-worth individuals. When you contribute to a DAF, the money goes into an account with your name. You are permitted to take the full charitable deduction in the year it was made, even though the funds might not be dispersed to charity until later. However, as with donations to charity groups, taxpayers should be certain donations to the DAF are deductible.

5. Pay up Your Expenses

Another way to shelter a bonus or windfall is to pay upcoming deductible business or personal expenses before Dec. 31. You might consider upgrading your computer equipment or footing utility bills for your home office before year-end. Using a credit card may make sense, provided you can pay off the additional balance in January.

Another idea: If you’re signed on for a health savings account at work, consider using part of your bonus or windfall to pay up to the contribution limit. Just be sure it’s money you can carry over to next year, or that you know you will spend in time.

The Bottom Line

As soon as you know of a bonus or windfall, book a meeting with your tax advisor to start safeguarding as much as you can. “Like a lot of tax issues, things can get very complicated,” says Sutch. “You don’t want to get whipsawed on some of the more intricate rules, so it’s a good time to lean on a competent tax adviser’s advice.”

The only windfall that won’t put you in that situation. In 2021, the amount that some can give you tax-free is $15,000, and it goes up to $16,000 in 2022. Neither you nor the giver owes taxes on a gift that falls within the legal limit. Such gifts can add up: For example, if all four of your grandparents gave you the maximum, you could collect $60,000 in 2021, gift-tax-free.

Article Sources

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  1. Internal Revenue Service. "Publication 15 (2021), (Circular E), Employer's Tax Guide." Accessed Nov. 26, 2021.

  2. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2020." Accessed Nov. 26, 2021.

  3. Internal Revenue Service. "IRS Announces 401(k) Limit Increases to $20,500." Accessed Nov. 26, 2021.

  4. Internal Revenue Service. "Publication 590-A (2020), Contributions to Individual Retirement Arrangements (IRAs)." Accessed Nov. 26, 2021.

  5. Internal Revenue Service. "Topic No. 409 Capital Gains and Losses." Accessed Nov. 26, 2021.

  6. Internal Revenue Service. "Publication 530 (2020), Tax Information for Homeowners." Accessed Nov. 26, 2021.

  7. Internal Revenue Service. "Estimated Taxes." Accessed Nov. 26, 2021.

  8. Internal Revenue Service. "Publication 526 (2020), Charitable Contributions." Accessed Nov. 26, 2021.

  9. Internal Revenue Service. "Donor-Advised Funds." Accessed Nov. 26, 2021.

  10. Internal Revenue Service. "Publication 969 (2020), Health Savings Accounts and Other Tax-Favored Health Plans." Accessed Nov. 26, 2021.

  11. Internal Revenue Service. "What's New-Estate and Gift Tax." Accessed Nov. 26, 2021.

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