For a lot of people, the end of the year is a time of celebration. Not just because of the holidays and family — but also for the big end-of-the-year bonus that gets paid out for all the work you've done over the last 12 months.
More than half of all employers give out a year-end bonus that might be monetary in nature or come in the form of other benefits like gifts cards or employee gift registries. Monetary bonuses can differ in appearance too from direct paycheck compensation to 401(k) contributions.
Some people refer to this type of bonus as a Christmas bonus. While bonuses have experienced a downward trend over the last few years due to the recession, the average bonus was about 1.3 months of salary in 2013, according to JobsDB.com.
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Wall Street Takes the Cake for Year-End Bonuses
It's no secret that the biggest year-end bonuses go to those who work on Wall Street. These bonuses can run from a few thousand for a secretary to millions for higher-level management. In 2013, the average Wall Street bonus rose 15 percent to $164,530, according to The New York Times.
That's still tame compared to the biggest bonuses paid out to Wall Street executives. The top three bonuses of 2013 — paid to Michael Farrell, Ian Cumming and Leslie Moonves — alone added up to around $84 million, according to Forbes. Farrell's bonus was earned on only a partial year of work.
While we can safely assume these people have a huge tax bill at the end of the year, you might be surprised to know that — whether you received one hundred thousand dollars or just a few hundred bucks — the tax rate on bonuses remains the same for most.
How Your Bonus Gets Taxed
The first thing you'll probably notice when receiving a bonus check is how much gets taken out in taxes. It's not complicated, and it is taxed under a different set of rules than your standard income is.
Bonuses, commissions and prizes are all considered supplemental wages and are subject to a supplemental wage tax. If you have more than one million in supplemental wages for the year, your employer must withhold tax at the highest federal rate of 39.6 percent. If it's less than that amount, then it depends on how the wages are paid. If your bonus is not designated as a supplemental wage, taxes are withheld based on your W-4 form. However, if this income is noted separately, your employer must withhold 25 percent or combine your regular and supplemental earnings in one pay period and apply the regularly withholding rates.
Note how this tax could differ from a graduated income tax, which is adjusted based on income bracket.
Putting That Bonus to Work
The most exciting part of getting a bonus is deciding how to spend it. Many financial planners like to use the 50-30-20 rule: 50 percent of your budget toward necessities (food, water, shelter, transportation etc.) and paying down debt, 30 for discretionary use, and 20 percent toward savings.
Instant paydays are easy to celebrate and can provide an excuse for lavish spending, at least once a year; however, a more appropriate use of that bonus is to get yourself more organized financially.
If you have debt, that bonus can wipe it out or at least reduce it substantially. You'll save money on interest payments over the long term and improve your credit score, as well, which will lead to even more savings moving forward.
A good financial plan includes at least three to six months worth of emergency savings built up. If you haven't done that, you might consider funding an emergency account. You never know when the unexpected will happen and knowing that you're prepared take a lot of worry and stress out of unforeseen circumstances.
The holiday season is also a period of budget busting, as the average shopper will spend $804.42 this year celebrating Christmas, Hanukkah or Kwanzaa, according to the National Retail Federation. Much of this spending will end up on credit cards, which could take shoppers several months to pay off, potentially at the detriment of their credit scores.
Of course, working all year long and having nothing to show for it isn't a great reward system. If your finances are squared away, go ahead and splurge a little, as this could also be a good opportunity to indulge and fight off frugal fatigue. Take the family on vacation or buy something you know you'll enjoy. If you've made sure to put some of that bonus toward debt and savings to make financial progress, if needed, then you can spend the rest guilt free.