Everybody loves to receive their annual bonus or additional compensation for a job well done. Usually, we are so excited about the extra money and planning how to use it, that potential tax implications that could come with it are overlooked.
Receiving a substantial bonus could push you into the next tax bracket unknowingly, potentially leading to phasing out of different deductions and credits, causing you to have a higher tax liability. In addition, many employers do a flat 22% withholding on bonus income, which may not be enough if you are in a higher tax bracket. This may result in an unexpected balance due and possibly penalty when filing your return.
Bonus income doesn’t always come in the form of cash. Many companies award stock-based compensation, which has its own complexities. Depending on the type of stock award you receive, the options can be taxed at different times and in different ways. Often when you are awarded this type of compensation, it is almost like phantom income, because you may have to recognize the income before actually receiving the cash. Some types of stock can even be taxed twice, through different types of tax. It is possible to pay income tax once is vests, and later on pay capital gains tax when the shares are sold.
One example would be non-qualified stock options. At time of grant, there is no cash in hand or income tax due. However, once you decide to exercise (sell) those shares, you are subject to payroll tax (Fed, State, FICA) on the difference between the selling price and the cost at time of receiving.
Another example would be restricted stock, these are considered ordinary payroll income at time of vesting. This typically shows up on your paystub and is subject to all payroll tax. Once those options vest, you have the ability to sell them for cash or keep them as common stock. If you decided to sell them later on, you could be subject to short- or long-term capital gain/loss on the difference of value at vest and sale value depending on the amount of time you hold the stock.
Bottom line, while bonuses or stock award compensation are great rewards, there could be unexpected tax consequences. Periodic tax check-ins throughout the year can help to ensure you stay on track and your entire tax picture is taken into consideration.