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 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. On the other hand, a bonus might bump you into a higher tax bracket, which starts at 10% for low-income taxpayers and tops out at 37%.

One more thing to look out for, notes Rosalind Sutch, a Philadelphia certified public accountant (CPA) at the tax consulting firm Armanino LLP: "If you work in two or more states during the year, you might need to pay taxes on your bonus to each state."

Below are five strategies that may help you keep as much of that extra cash as the IRS allows.

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 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 maximum amount you can contribute to your 401(k) or similar workplace retirement plan is $22,500 for the 2023 tax year, while the catch-up contribution increases to $7,500 for those age 50 or older. For the 2024 tax year, the maximum increases to $23,000 while the catch-up contribution stays at $7,500.

Keep in mind that when changing your 401(k) allocation through your employer, there may be a delay before they are recorded in the payroll department. This can be critical when planning for a windfall received at the end of the year.

IRAs

Your total contributions to all of your traditional and Roth IRAs cannot be more than $6,500 for the 2023 tax year, plus $1,000 if you're age 50 or older. The maximum increases to $7,000 in the 2024 tax year and the catch-up contribution remains at $1,000.

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.

In regards to timing, you may be able to make contributions to an IRA in one year relating to a previous year. For example, should you receive the windfall on the last day of 2023, there are situations in which you can make eligible contributions up until the 2023 tax filing deadline of April 15, 2024.

Roth IRA

Another strategy, says Sutch, is to make a contribution to a non-deductible IRA, then convert the account to a Roth IRA 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.

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 consider 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.

3.?Pay Your Taxes

Yes, the heading here sounds like a no-brainer. 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 sidestep an IRS penalty for coming up short.

Under certain circumstances, you might be able to?pay next year’s real estate taxes in advance. It 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.

As with any donations, the taxpayer should be certain that the donations to the DAF are deductible.

5. Pay 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 you're about to get a bonus or windfall, you might book a meeting with a tax advisor to consider ways to reduce the taxes you'll owe on it.

"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.”