April 16: Lessons From This Tax Season – and How to Avoid Surprises Next Year

After 40 years of preparing returns, the most common frustration I observe is not simply owing taxes, but not understanding why, especially when clients have only W‑2 wages. This confusion usually stems from how withholding works, not from any error. You followed the law, but the amounts withheld from your paychecks did not match your actual tax liability. For higher earners, the main issue is often how tax withholding is calculated for bonuses and other supplemental wages.

Why you can owe even with W‑2 wages

• Employers often withhold federal tax on bonuses at a flat supplemental rate (generally 22% on the first $1 million of supplemental wages). That rate is set by IRS withholding rules; it is not your actual tax rate.
• Your actual marginal federal income tax rate may exceed 22%. For many households, it is 24%, 32%, 35%, or 37%. If your bonus is withheld at 22% but your income places you in a higher bracket, your prepayments will likely be insufficient.
• This applies not only to cash bonuses. Commissions, severance, vested restricted stock units (RSUs), and certain prize or award income may also be treated as supplemental wages and subject to the 22% rate.
• As a result, bonuses paid early in the year may seem like extra take-home pay. However, during tax filing, you may discover that a portion should have been withheld, leading to a balance due and potential underpayment penalties.

Note: Employers may use either a flat “percentage method” (commonly 22%) or an “aggregate method” (taxing the bonus as if added to a regular paycheck and using your marginal rate). Large companies often use the flat method by default.

Planning moves to avoid surprises

Ask payroll to withhold more on the bonus

• Before your bonus is paid, request additional federal withholding for that specific payment. Many payroll systems allow you to specify an extra dollar amount.
• Alternatively, submit an updated Form W‑4 before the bonus is paid to add an amount on line 4(c) (“Extra withholding”). You can update the form again after the bonus if you wish to revert to your previous settings.
• If your company uses the aggregate method, ask how that will affect the withholding on the bonus check.

Make quarterly estimated tax payments

• If payroll cannot adjust withholding or you receive significant supplemental income, such as RSU vesting, during the year, consider making estimated tax payments.
• Estimated payments are typically due in April, June, September, and January for the prior quarter’s income. Paying throughout the year helps manage cash flow and reduces the risk of underpayment penalties.

Use the safe harbor rules

• You can avoid underpayment penalties if you pay in, through withholding and estimates, at least:
  • 90% of your current‑year total tax, or
  • 100% of your prior‑year total tax (110% if your prior‑year adjusted gross income exceeded $150,000; $75,000 if married filing separately).
• Safe harbor planning is useful if your income fluctuates or you receive variable bonuses or stock vests. Set aside funds from your bonus and either prepay estimated taxes or increase withholding to meet safe harbor requirements.

Remember: Withholding “counts” evenly throughout the year

The IRS treats withholding as if it occurred evenly throughout the year, regardless of the actual timing. Therefore, increasing withholding late in the year, such as on a November or December paycheck, can be more effective in reducing or eliminating underpayment penalties than making a late-year estimated payment.

Run a midyear projection

• In June or July, total your year-to-date wages, bonuses, equity income, withholdings, investment income, and deductions.
• A quick projection with your tax advisor or a reputable withholding estimator can help you identify any shortfall while there is still time to address it.

Segregate your “tax cut” of the bonus

• When you receive your bonus, immediately transfer an estimated tax portion, often 30% to 40%, depending on your federal and state brackets, into a separate tax reserve savings account. Adjust this amount as your projections are updated.
• This approach helps prevent you from spending funds that will ultimately be needed for taxes.

Coordinate other variables that push up taxes

• Investment moves: Large capital gains, mutual fund distributions, or Roth conversions can push your effective rate higher.
• Phaseouts and surtaxes: Higher income can reduce credits and deductions, or trigger the 3.8% Net Investment Income Tax or Additional Medicare Tax.
• Life events: Marriage, a second earner, dependents aging out of credits, or reduced itemized deductions can change your outcome.

Fine tune benefits to reduce taxable income

Maximize pre-tax 401(k), 403(b), or 457 contributions, HSA (if eligible), and dependent care accounts when appropriate. While these will not resolve under-withholding on a bonus alone, they can reduce your overall tax liability.

What about state taxes?

Many states apply a flat supplemental withholding rate on bonuses, which may exceed your average state tax rate. As a result, you may receive a state refund even if you owe federal taxes. However, practices vary widely by state and employer, so do not assume over-withholding. Include state tax implications in your midyear projection to avoid surprises.

To learn more about steps you can take to avoid surprises come tax season, contact our CBIZ tax professionals.