Overtime, bonuses, and how they are taxed

In short

I once sat beside a woman in a waiting room who had turned down every offered shift of overtime for a year because she believed the extra pay would push her into a higher bracket and leave her with less money than if she had stayed home. She was furious when I sketched the arithmetic on the back of a magazine. Overtime and bonuses are taxed as ordinary income in the period you receive them, and withholding often takes a larger bite up front because your payroll system assumes that one large check represents your new permanent pace of earning. The bracket system taxes only the dollars that land inside each bracket, so a single dollar over the line costs you only the marginal rate on that one dollar. When you file your return, the withholding is trued up against your actual total income, and any over withholding comes back as a refund.

The whole of it

What it is

You have probably opened a pay slip after a weekend of overtime or a year end bonus and felt a wave of disappointment at the withholding. Overtime wages are dollars you earn for hours beyond your regular schedule, typically beyond forty hours in a workweek, and many employers pay them at time and a half under the Fair Labor Standards Act. Bonuses are lump payments tied to performance, tenure, or profit sharing. Both are compensation for services, so both are ordinary income under the Internal Revenue Code. The tax code does not set aside a separate higher rate for these payments. They join your salary, your tips, and every other dollar of wages on the same Form W‐2 at the end of the year, and all of it is taxed under the same graduated bracket table.

How it works

A friend of mine received his first commission check and called me in a panic because forty percent had disappeared. The withheld amount was high, but his actual tax bill was not. Withholding is an estimate. When your employer cuts a check that is larger than usual, the payroll software often applies a flat supplemental withholding rate or annualizes that one check, assuming you will earn that amount in every pay period for the rest of the year. Under IRS rules found in Publication 15 (Circular E), if your employer identifies the payment as supplemental, it may withhold at a flat the current figure, which the official source publishes each year on the first the current figure, which the official source publishes each year of supplemental wages in a year and the current figure, which the official source publishes each year on anything beyond that threshold. If the payment is combined with regular wages or the employer chooses the aggregate method, the system calculates withholding as though the total were your new recurring pay. Either way, the withholding is merely a prepayment. It is not your tax.

When you file Form 1040, you list your total wages from box one of every W‐2. You then subtract your standard or itemized deductions to reach taxable income. That income is split into brackets, and each bracket is taxed at its own rate. The first dollars are taxed at the current figure, which the official source publishes each year, the next segment at the current figure, which the official source publishes each year, and so on until you reach the top of your income. Only the dollars that fall inside a higher bracket pay the higher rate. The tax you owe is compared to the total withholding reported in box two, and any excess withholding is refunded. Any shortfall is a balance due.

The numbers, and where to find yours

If you want to see the current graduated brackets, open the instructions for Form 1040 and turn to the Tax Table or Tax Computation Worksheet. The IRS publishes these every autumn for the coming filing year. The supplemental wage withholding rates live in Publication 15 (Circular E), the guide for employers. Your own withholding depends on the Form W‐4 you gave your employer. Box one of your W‐2 will show total wages. Box two shows total federal tax withheld. If your employer uses supplemental withholding, you may see a note on your pay stub, but the W‐2 does not break out which dollars were regular and which were overtime or bonus.

State rules vary. Some states apply a flat withholding to bonuses; others follow the federal aggregate method. Check your state's department of revenue website or your pay stub detail.

A worked example

Imagine a woman named Clara who earns 52,000 dollars in salary and who files as single. Her employer offers her 4,000 dollars in overtime during the year and a 2,000 dollar year end bonus. Her total wages are 58,000 dollars. On the bonus check, the payroll system withholds 22 percent under the supplemental rate, removing 440 dollars. It feels steep. At tax time, Clara takes the standard deduction of the current figure, which the official source publishes each year, leaving her with taxable income of 44,300 dollars if the standard deduction were 13,700 dollars. The first the current figure, which the official source publishes each year is taxed at the current figure, which the official source publishes each year, producing 1,160 dollars. The remaining 33,550 dollars is taxed at the current figure, which the official source publishes each year, adding 4,026 dollars, for a total tax of 5,186 dollars. Her W‐2 shows she had 6,200 dollars withheld across the year. She receives a refund of 1,014 dollars. The overtime and bonus did not cost her anything. They added to her refund.

Where it goes wrong

I once watched a man refuse a small raise because he believed the raise would land him in the next bracket and cost him money. He had confused marginal rates with average rates. A higher marginal rate applies only to income above the bracket threshold, not to every dollar you have ever earned. The fear of brackets is a myth that costs people real money in foregone opportunity. Another common error is assuming that withholding is tax. Withholding is a guess made paycheck by paycheck. Tax is the final calculation on your completed Form 1040, worked from the whole year. If your bonus arrives in December and withholding is high, you may feel poor in December but you will see the correction in your refund by April.

A third mistake is failing to adjust your W‐4 when income becomes lumpy. If you know you will receive a large bonus or months of overtime, you can file a new W‐4 and use the entries in steps three and four to adjust the amount your employer withholds from each paycheck, smoothing your cash flow. The IRS Tax Withholding Estimator on irs.gov walks you through the arithmetic. None of this changes your final tax. It only changes the timing.

Questions to answer before you leave this page

What did box one of your most recent W‐2 report as total wages, and does that figure include every bonus and overtime payment you remember receiving? If you received a bonus this year, what percentage was withheld, and does your pay stub label it as supplemental? Have you opened the instructions for Form 1040 and found the tax table for your filing status so you can see where each bracket begins and ends? When you compare the withholding in box two to the tax you calculate by hand, do you come out ahead or short? If you expect lumpy income next year, have you visited the withholding estimator and considered filing a new W‐4 so that less is taken out when the checks are steady? If someone once told you that overtime is not worth it because of taxes, can you now sketch the bracket math on a napkin and show them why every extra dollar leaves you with more money than you had before?