Bonuses (perhaps most common around the holidays) are important in attracting and retaining top talent in any industry. As a business owner, you want to reward employees for a job well done, but you also need to consider what implications may be associated with your method of giving bonuses. For example, what's the difference in cost for your business if you give cash bonuses compared to making a contribution to your employees' retirement account? It may be the right alternative for you that could mean a "bigger" bonus for your employees, as well as a bigger savings for your company.
Let's explore both scenarios in more detail, and take a look at the numbers to see what the true cost of the bonus is for both the employee and the small business owner. Let's look at the cash bonus first.
Meet John Smith, our employee, and let's give him a $5,000 bonus. Now the IRS considers any monies paid to you either by others (self-employed) or by a business (employer) as income. Therefore any bonus paid to John is considered "Taxable earned income" and obviously is taxable. Since the employer has decided to give a bonus to its employees, the employer then has the option of withholding tax at the same rate of your regular paycheck or a flat 25 percent in regards to "Annual Bonus Payments." Assuming the employer elects the flat 25 percent withholding rate, this earned income is also subject to both Social Security taxes as well as Medicare taxes. Assuming John makes less than $110,100 this year, Social Security taxes will be withheld at a rate of 6.2 percent. In addition, a Medicare tax of 1.45 percent will also be withheld from the bonus. So, when all is said and done, the total withholding from John's $5,000 bonus is 32.45 percent or $1,623. This leaves John with a bonus of $3,377.
Now let's look at it from the small business owners' perspective. As an employer, you are required to contribute matching amounts for both the FICA and Medicare taxes. Also, this employer contribution may not be deducted from the employee's wages; therefore the additional 7.45 percent in taxes is over and above the wages paid to the employee. So that $5,000 dollar bonus is really costing you $5,373.
Now let's look at the bonus option of making a contribution on behalf of the employee into the company's retirement savings plan. Again, assuming the same employee, John Smith gets a $5,000 bonus. Instead of a cash bonus, the employer makes a $5,000 contribution into the company's 401(k) profit sharing plan on John's behalf.
This bonus option is a before-tax contribution and not subject to any of the tax withholding mentioned above. This is a dollar-for-dollar bonus and John will have an additional $5,000 sitting in his account for his enjoyment in retirement. Because the 401(k) profit sharing plan is a tax-deferral instrument, no taxes will be paid until distributions are made. Although taxes and penalties may apply if distributions are made prior to the age of 59.5, all contributions and earnings enjoy the benefit of tax-deferred growth.
Now let's look at it from the small business owner's perspective. All employer contributions for retirement accounts are considered a deductible expense and are deducted from the employer's taxable income. Again, since this not hitting the employer's bottom line, this money is not subject to FICA or Medicare taxes.
We understand the above example assumes that a retirement plan is already in place. The consensus is that retirement plans are complicated and expensive to set up. This is sometimes the case. Although there are many options available for small businesses that may be both simple and inexpensive. Also, when considering the true cost of cash bonuses, the cost of setting up the plan may be minimal.
Now that tax season is behind us, this is a great time to be thinking about areas for improvement for next year. Be informed about what options are available to you, and speak with your financial and tax advisor to get the best advice on your specific bonus structure, retirement plans, and their unique tax ramifications.
Tom Prutzman and Kyle McCann are Principals at Prutzman Wealth Management in Reno. Contact them at 996-5672 or through www.prutzmanwm.com.
