🔥 How to keep your big bonus big after taxes

☕Good morning! 

Welcome to another week of Making Cents of Your Money, where we’re serving up tax tips hotter than the burger patties off a Blackstone this 4th of July. 

This week, we’re talking big bonuses and, more importantly, how to keep them big after Uncle Sam gets his cut. 

🥳 Every bonus type rewarded to employees comes with unique tax considerations.

Formally defined by the IRS,

We won’t get into the specifics of determining the Fair Market Value of that sales reward trip to Cancun, but let’s explore how to keep more of your bonus money in its most popular forms. 

💸 Cash Bonuses: Immediate Gratification, Immediate Taxation

Cash bonuses are taxed as ordinary income, which includes federal, state, Social Security, and Medicare taxes. 

✅ Pros: immediate liquidity– the cash (sans withholding) hits your bank, and it’s yours. 

❌Cons: If your bonus is substantial, it could push you into a higher marginal tax bracket, resulting in part of your income being taxed at a higher percentage.

📈 Stock Options: Where Timing and Type Make All the Difference

Let’s explore three popular forms of high-level employee comp– NSOs, ISOs, and RSUs.

Nonqualified Stock Options (NSOs) are taxed at the time of exercise. The difference between the exercise price and the stock’s market value (the “bargain element”) is treated as ordinary income and reported on your W-2 or 1099 form.

Incentive Stock Options (ISOs) are more tax-favorable if held for at least one year after exercise and two years after the grant date, as they are then taxed at the capital gains rate. Otherwise, they revert to being taxed like NSOs.

Restricted Stock Units (RSUs) are a double whammy.

First, they’re taxed as ordinary income when they vest. The taxable amount is determined by the fair market value of the shares. 

Second, if you hold onto the shares, any future gains or losses will be taxed as capital gains or losses.

✅ Pros: often an exclusive way to gain access to company stock at a hearty discount. 

❌Cons: you owe tax in dollars, which requires advance planning to avoid cash crunches.  Let’s say $150,000 of your RSUs vest in a high-income year and are taxed at 35%. You’d owe $52,500 in taxes that must be paid in cash.

This could deplete your savings account or require you to sell other more liquid positions to cover the bonus windfall. You could consider selling a portion of the RSUs immediately to cover the tax liability, thus avoiding the need to dip into personal savings, but still, it’s a bit more complicated (but not necessarily preferable) than cash. 

🏆 Performance-Based Bonuses are Taxed Like Your Salary

🎉You hit that performance milestone, and it’s time to cash in. 

Performance-based bonuses can be paid in cash, stock options, or additional RSUs, depending on your company's compensation structure, and are tied to achieving specific targets. 

They’re treated with the nuances for each category noted above, but you can expect to pay some ordinary tax in most cases.

♟️Keeping More of Your Bonus: The Offense

Tax planning is chess, not checkers.

Like all deeply involved strategy games, expert financial planning isn’t a mere action/reaction tit-for-tat series of reactionary moves. It requires using every piece on the board to craft a significant advantage, not just for this year but for decades to come. 

Employers typically withhold taxes on bonuses at a flat rate of 22% for amounts under $1 million and 37% for amounts over $1 million, which typically covers most of what you’d owe depending on your tax bracket. 

⏰ For starters, timing your bonus can make an enormous difference. For example, if you can work with your employer on it, receiving your bonus on January 1 instead of December 31 can defer the tax liability to the following year, saving you thousands of dollars or at least giving you ample time to get other tax-saving strategies in motion. 

💼 Max out your 401(k) contributions to reduce taxable income. For 2024, the limit is $23,000, with an additional $7,500 catch-up for those 50 and older.

📉 Sell investments with lost value to offset capital gains from other investments, reducing the tax owed a la tax-loss Harvesting. You can also use tax-loss harvesting to offset capital gains from RSUs or stock options– losses must offset gains of the same type before being applied to other income. You can use up to $3,000 of your losses to offset ordinary income per year, and the rest rolls over. 

🏥 Health Savings Accounts (HSAs) offer triple tax benefits: contributions are tax-deductible, grow tax-free, and withdrawals for qualified medical expenses are tax-free. Health-related expenses (in the fairly broad category specified by the IRS) are inevitable, so why not use tax-advantaged money? 

🎁 Charitable giving to Donor-Advised Funds (DAFs) can provide immediate tax deductions and allow you to plan charitable giving over time. You can also contribute appreciated stock to a DAF to maximize deductions and avoid capital gains tax.

🛡️ Keeping More of Your Bonus: The Defense

A high marginal tax rate is one thing, but other tax threats lurk in the shadows. 

💰Large bonuses can trigger the Alternative Minimum Tax (AMT), a parallel tax system designed to ensure high earners pay at least a minimum amount of tax, regardless of deductions and credits. 

To avoid surprises, work with a financial planner to model different scenarios to help you understand your potential AMT exposure and develop strategies to minimize it.

🌎 Location also matters big time.  If you live in a high-tax state like New York or California, your state (and city) taxes can eat into your bonus. 

Some professionals time a move to a lower-tax state around their bonus payout. This requires documentation and careful planning, such as changing their driver’s license, voter registration, and primary address to establish residency.

If moving isn’t an option, explore any state-specific deductions or credits that can help reduce your tax burden. For example, you may find that the SALT deduction may shave a significant chunk off your federal income tax. 

💰In another edition of “more money, more problems,” the Net Investment Income Tax (NIIT) is an additional 3.8% tax on investment income for high earners with a modified adjusted gross income (MAGI) exceeding $200,000 for single filers or $250,000 for married couples filing jointly. 

Although this only taxes investment income, not your bonus income, your bonus could push you above the threshold that exposes your investments to that additional 3.8% tax. 

🏃 Making Cents of Big Bonus Taxation

We’ve covered a lot of ground today, from the intricacies of cash bonuses, stock options, and RSUs to strategic tax planning tips. 

Remember, thoughtful planning and proactive strategies are the keys to maximizing your bonus and minimizing your tax burden.

Though there are some last-minute year-end actions you can take to reduce your tax burden, kicking off July with a holistic review of your financial picture with a financial planner can amplify your efforts. 

Whether it’s timing your bonus to fall in a lower tax year, leveraging retirement contributions, or utilizing tax-loss harvesting, every move counts. And don’t forget the defensive plays like understanding the implications of the AMT and NIIT, and considering state-specific tax benefits or even relocation.

Keep these tips in mind, and you’ll be well on your way to making the most of your earnings while keeping Uncle Sam’s cut to a minimum.

Until next week!

Dan from Tailored Cents

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