When one of your clients receives a bonus, you may be among the first to know if they wish to invest it. Before you do, however, it’s important to make sure your client fully understands the tax obligations that come with it.
Often, supplemental payments—such as bonuses, equity compensation, and even exercising non-qualified options—can leave the recipient with an unexpected tax bill. Here’s how you can help your clients avoid this rude awakening.
How does a supplemental payment lead to a surprise tax bill?
A supplemental payment is a one-time compensation that falls outside of an employee’s regular payroll. The federal withholding rate for supplemental payments under $1 million is 22%; the rate jumps to 37% for anything over $1 million.
This is where things get complicated: The 22% federal income tax bracket is capped for individuals at $86,375 and for married couples filing jointly at $172,750. If your client were to fall in a higher income marginal tax bracket, this would create a withholding rate differential between the supplemental payment and their regular payroll.
For instance, say your client is in the 22% tax bracket, but they receive a supplemental payment that bumps them into the 32% tax bracket. Now the 22% withholding on the supplemental payment is no longer adequate. Because the client was bumped into the 32% bracket, the supplemental payment they received was under withheld by 10%—which undoubtedly will show up on their tax bill.
When can a surprise tax bill become a problem?
Clients are often confused about this because they know withholding was on their supplemental payment—they just didn’t realize it wasn’t enough.
Unfortunately, many individuals use supplemental payments for investments or luxury purchases. This means the money isn’t readily available to pay the additional, unforeseen tax. It can quickly become a cash-flow problem.
This is largely a federal tax issue; most states keep their supplemental payment rates closer to or the same as the income tax rates.
What should do you as an RIA?
If your client comes to you and wants to invest their supplemental payment, consider pumping the brakes on their enthusiasm. Make sure your client understands their tax obligations, so they won’t be hit by unexpected tax due in April.
Your job: Be the hero.
As you know, expectations make all the difference. If you can step in early and say, “hey, let’s make sure you won’t owe anything else on this bonus,” you can be the hero who saves your client from a surprise tax bill.
If you think your clients could benefit from this type of tax advice, we’re here to help. We can work as your in-house tax advisor to make sure your clients aren’t left scrambling to deal with unexpected tax payments. To learn more, contact us today.