Should I Really Withhold 401(k) from My Bonus? – Avoid This Mistake + FAQs

The IRS Green Light on Bonus Contributions: Under federal law, bonuses are generally treated as ordinary wages for retirement plan purposes.

This means if your employer’s 401(k) plan defines “compensation” to include bonuses (and most do), you can elect to defer part of your bonus into the 401(k).

The Internal Revenue Code and ERISA allow employees to contribute a portion of eligible pay – including annual incentives, commissions, and other bonuses – into tax-advantaged retirement accounts.

There’s no federal mandate forcing you to contribute your bonus, but federal rules set the stage by permitting it.

Tax Breaks and Limits: Contributing bonus dollars to a traditional 401(k) gives you a federal tax break upfront. Any amount you defer isn’t counted in your taxable income for the year (except for Social Security and Medicare taxes, which still apply).

This can be powerful: bonuses often face a flat 22% federal withholding tax (and even 37% on portions over $1 million). By redirecting some of that bonus to your 401(k), you shield it from immediate income tax and potentially drop into a lower tax bracket for the year.

Remember, however, the IRS annual contribution limit – $22,500 for 2023 (rising to $23,000 in 2024, plus an extra $7,500 if age 50+) – applies to your combined 401(k) contributions from salary and bonuses.

If you’ve already been contributing heavily during the year, a large bonus deferral could push you over this limit, triggering a need to refund the excess.

Plan Documents Rule the Game: Federal law gives plans flexibility in defining what counts as compensation. Most 401(k) plans count bonuses by default (following IRS safe harbor definitions of compensation).

However, an employer can choose to exclude certain bonuses or types of pay in the plan terms. For example, a plan might exclude signing bonuses or overtime from 401(k) calculations.

But there’s a catch: under IRS regulations (IRC §414(s)), if a plan deviates from the standard comp definition, it must pass a nondiscrimination test (the “compensation ratio test”) to ensure highly paid employees aren’t unfairly benefiting.

In short, federal law says bonuses can be part of your 401(k) contributions, but the plan’s fine print decides the specifics.

Mandatory Withholding vs. Voluntary Deferral: It’s important to clarify terminology: federal law requires employers to withhold taxes on bonuses (the IRS sees bonus pay as “supplemental wages” with specific withholding rules), but 401(k) withholding is voluntary.

You must elect to contribute a portion of your compensation to a 401(k); your employer then withholds that amount from your paycheck or bonus and deposits it into your 401(k) account. Federal law does not force any set percentage – it’s your choice (subject to plan limits like a 50% of pay deferral cap in some plans).

However, once you make an election, your employer is legally obligated to follow it for all forms of compensation that are eligible.

For instance, if you’ve chosen to contribute 10% to your 401(k) and you get a $10,000 bonus, the employer should withhold $1,000 into your 401(k) unless you change your election beforehand.

Failing to do so (not honoring your deferral choice on a bonus) can actually put the plan out of compliance with federal law, as seen in some legal disputes.

State-by-State Nuances: Will Your State Rain on Your Bonus Parade?

State Tax Treatment – The Pennsylvania Curveball: While federal tax law gives a clear incentive to defer bonus income into a 401(k), state taxes can differ. Most states mirror the federal treatment, meaning they don’t tax 401(k) contributions and only tax the money when you withdraw in retirement.

For example, if you work in California or New York and put part of your bonus into a 401(k), those contributions reduce your state taxable income in the current year just like they do for federal taxes. However, a notable exception is Pennsylvania.

Pennsylvania state law considers 401(k) contributions as taxable income in the year earned – yes, even pre-tax contributions. If you earn a $5,000 bonus and defer $1,000 to your 401(k), Pennsylvania will still tax you on the full $5,000 now (though your money grows tax-deferred and won’t be taxed again by PA upon withdrawal).

This means the immediate state tax benefit of 401(k) contributions doesn’t exist for Pennsylvania residents. It’s a small nuance, but it can affect the net gain of sheltering your bonus in a retirement plan.

States with No Income Tax or Unique Rules: In states like Texas, Florida, or Nevada, state income tax is a non-issue – your bonus isn’t taxed at the state level at all, whether you contribute to a 401(k) or not.

Meanwhile, states such as New Jersey partially diverge on retirement contributions (for instance, New Jersey allows the federal tax break on 401(k) contributions, but not on certain other plans like 403(b)s or IRAs). Always check your own state’s stance.

The majority of states are “401(k)-friendly,” but a few have quirky rules that affect either contributions or taxation of retirement accounts.

Understanding these can refine your strategy: in a no-tax state, the benefit of deferring bonus money is purely federal, whereas in high-tax states, each dollar funneled to 401(k) saves you potentially significant state tax as well.

Wage Laws and Bonus Payout Timing: State laws also govern how and when bonuses are paid, which indirectly impacts 401(k) contributions. For example, California law mandates prompt payment of earned bonuses (they’re considered wages).

If you earned a bonus, even if you leave the company, California requires that bonus to be paid out, typically in your final paycheck or soon after. If you’re still employed when the bonus pays out, your 401(k) election would apply to it.

But if the bonus is paid after you left the company, you usually can’t defer it into the 401(k).

You’re no longer an active participant – unless your plan has a special provision covering post-termination bonus pay (an issue at the heart of some lawsuits, as we’ll see).

Additionally, some bonuses are conditional on continued employment (like retention bonuses or certain annual incentives). State labor laws vary: some states allow employers to require forfeiture of a bonus if you resign before the payout date, while others may require pro-rated payouts.

These conditions determine if you even receive the bonus to begin with – no bonus, no 401(k) contribution. In short, whether your bonus materializes (and when) can depend on state law and your contract, which in turn affects any retirement contribution plans you had for that money.

State Retirement Mandates: A growing number of states have their own retirement savings programs (such as California’s CalSavers, Illinois Secure Choice, etc.) for workers at companies that don’t offer a 401(k). If you’re in one of those programs due to your employer not having a plan, your bonus could be subject to an automatic IRA contribution.

For instance, in California, if your employer uses CalSavers, a portion of your bonus might go into your Roth IRA under that program unless you opt out. The key difference: those state programs typically use after-tax contributions (Roth IRAs), so deferring a bonus into them won’t reduce your taxable income now.

Still, it’s good to know whether your state imposes any such arrangement, especially if you can’t participate in a 401(k).

Bonus Breakdown: 401(k) Strategies for Every Type of Bonus

Not all bonuses are created equal. Companies hand out various types of bonuses – and each type might come with its own rules or typical practices when it comes to 401(k) contributions.

Let’s unpack how annual bonuses, signing bonuses, retention awards, and performance payouts interplay with retirement savings.

Annual Bonus Bonanza: Year-End Rewards and Your 401(k)

An annual bonus (often given at year-end or early the next year based on company or personal performance) is a common candidate for 401(k) contributions. Since these bonuses are usually anticipated as part of compensation, employees often plan for them.

If you know a big year-end bonus is coming, you might increase your 401(k) contribution rate beforehand to put a chunk of that bonus into retirement. Many employers allow contribution changes with each pay period or at least before a bonus, so you could temporarily bump up your deferral percentage for the bonus paycheck.

Be mindful of limits: an especially large annual bonus could max out your annual 401(k) limit in one go. If, say, you already contributed $15,000 during the year and you get a $50,000 bonus, electing 15% of that bonus to 401(k) (which is $7,500) would hit the $22,500 limit.

Any extra deferral beyond the limit would have to be returned to you next year as an “excess contribution,” which is an avoidable hassle.

Another consideration is the employer match. Some companies match 401(k) contributions per pay period. If you pour a huge portion of your bonus into the 401(k) and reach the annual cap early, you might miss out on matching dollars in later pay periods (if your plan doesn’t do a year-end “true-up”).

For example, contribute the max by July (with the help of your bonus), and if your employer only matches when you contribute, those missed contributions in the fall mean missed match money.

A savvy strategy is to check if your plan offers a true-up (many do, crediting you the match even if you front-loaded contributions) or to spread out contributions a bit to capture the full match.

In any case, annual bonuses are prime opportunities to give your retirement a boost – just coordinate with the calendar and plan rules.

Signing Bonus Windfall: First-Day Pay and 401(k) Options

A signing bonus is a one-time amount offered when you start a new job, intended to entice you to join or to compensate for benefits you forfeited by leaving a former employer. Signing bonuses present a special scenario for 401(k) decisions.

The biggest factor is often eligibility: when you first join a company, you might not be immediately eligible to enroll in the 401(k) plan. Many plans have a waiting period (e.g., 30 days, 90 days, or the start of the next quarter) before you can start contributing.

If your signing bonus is paid in your first paycheck or within that initial period, you won’t have a 401(k) account to defer into yet. In that case, the bonus will simply be paid fully in cash (with the usual tax withholdings).

You could still decide to invest some of that after-tax bonus into an IRA on your own, but you couldn’t defer it pre-tax into the 401(k) until you meet the plan’s eligibility requirements.

If, however, your signing bonus comes after you’ve become 401(k)-eligible (say the bonus is split, with half at hire and half after 6 months), you could contribute the later portion.

Another factor is that some signing bonuses come with clawback clauses – for example, if you leave the company within a year, you must repay it. Contributing a bonus that you might have to pay back can get tricky.

Imagine you put half of a $10,000 signing bonus into your 401(k), then you leave and owe the company $10,000 back. You can’t just pull the $5,000 out of your 401(k) (at least not without penalties and taxes) since it’s now protected in the plan.

Companies with clawback provisions may actually exclude those bonuses from 401(k) eligible compensation to avoid this issue. The bottom line for signing bonuses: check your 401(k) eligibility timing and the terms of your bonus.

If you can contribute and you plan to stay (so clawback isn’t a worry), a signing bonus can kickstart your retirement savings nicely. If not, you might allocate it to other uses or a personal IRA until you’re able to enroll in the 401(k).

Golden Handcuffs: Retention Bonuses and Long-Term Savings

Retention bonuses (sometimes dubbed “stay bonuses” or “golden handcuffs”) are paid to encourage you to remain with an employer through a critical period or project. Typically, you get a retention bonus after reaching an anniversary or project completion milestone.

By the time you receive it, you’re likely already participating in the 401(k) plan, so eligibility isn’t usually a barrier. You can treat a retention bonus much like an annual bonus when deciding how much to defer. One key consideration is timing and conditions: retention bonuses often require you to still be employed on the payout date.

If the payout is in, say, December and you’ve met the condition, it will be included in that paycheck’s compensation. Your standing 401(k) election would apply to it by default, or you could adjust your election during that pay period if desired.

However, retention bonuses can be sizable and are sometimes given to higher-level employees. If you are a highly compensated employee (HCE), large deferrals from a retention bonus might raise flags in nondiscrimination testing (if your plan isn’t a safe harbor plan).

In practical terms, if few others got bonuses or contributed as much, you might later get part of your contribution refunded to satisfy testing limits. It’s not a reason to avoid contributing, but be aware it could happen.

Another nuance: like signing bonuses, retention bonuses might have clawback rules (for example, if the bonus is paid but you leave within a year after, you must return it). If you’ve deferred some of that money into a 401(k), it complicates repayment.

Employers increasingly are cautious with this and may structure the bonus to pay out in installments or exclude it from the plan if a clawback applies.

From your perspective, if you know you’re sticking around to fully earn it, a retention bonus is a great candidate for 401(k) – you’ve lived without that money so far, so channeling a chunk into retirement won’t crimp your current lifestyle.

Performance Bonus Paydays: Commission and Incentive Payouts

Performance bonuses come in various flavors. They could be quarterly or monthly incentives for hitting sales targets, production bonuses on a manufacturing line, or project-specific awards for achieving certain results.

These are often more frequent and tied directly to individual or team metrics. Because they are part of your regular compensation structure, companies usually include them as eligible earnings for 401(k) deferrals.

If you earn commissions or regular performance bonuses, it’s wise to clarify with HR how those are handled: does your standing 401(k) contribution percentage apply to each bonus check automatically?

In many cases, yes – every time a bonus or commission payout happens, the payroll system will take out your elected percentage for the 401(k).

Some employers allow a separate election specifically for bonus compensation. For instance, you might contribute 5% of your regular salary but elect 0% or 10% specifically for bonus payouts.

They do this to give flexibility, since someone might want to treat a one-off bonus differently than regular pay. If your employer offers that, take advantage of the customization. If they don’t (most just use one election for all pay unless you change it manually), you can still plan.

For example, if you expect a big commission in a certain month and you’d like to put more of it into 401(k), you can temporarily increase your contribution rate before that paycheck, then reduce it afterward.

Just be mindful of the processing deadlines (some companies lock changes a week or so before payroll). Performance bonuses, especially for salespeople, can be a steady pipeline into your 401(k).

Just ensure you’re not accidentally exceeding limits if you have an unusually stellar quarter. Also, consider cash flow: if your income fluctuates with performance, maintain a contribution rate that still leaves you with enough take-home pay during lower bonus periods.

Bonus Type vs. 401(k) Eligibility and Considerations:

Beyond 401(k): IRA, HSA, and Other Ways to Invest Your Bonus

Putting all your bonus eggs in the 401(k) basket isn’t the only route. Depending on your financial situation, you might consider Individual Retirement Accounts (IRAs) or Health Savings Accounts (HSAs) as complementary or alternative ways to use that extra money.

Traditional or Roth IRA: If you’ve maxed out your 401(k) or your employer’s plan has limited investment choices or high fees, an IRA could be an attractive supplement. You can contribute up to $6,500 for 2023 (rising to $7,000 for 2024, with an extra $1,000 catch-up if over 50).

Traditional IRA contributions may be tax-deductible, but note: if you got a big bonus and your income is high, and you’re covered by a workplace plan, your IRA deduction might be reduced or eliminated due to IRS income phase-out rules.

In that case, you might favor a Roth IRA, where contributions are after-tax but qualified withdrawals are tax-free – essentially the opposite of a 401(k). Roth IRAs also have income limits, but high earners sometimes use a backdoor conversion strategy.

The key point is, an IRA gives you more investment choices and control. You’d be using your bonus (after tax, since it’s outside payroll) to fund it, which is fine if you’ve already paid tax or if the IRA is deductible you’ll get some tax benefit at filing time.

Health Savings Account (HSA): If you are enrolled in a high-deductible health plan, an HSA is another powerful vehicle. HSA contribution limits (for 2023, about $3,850 for individuals or $7,750 for family coverage, plus $1,000 extra if age 55+) are lower than 401(k)s but come with triple tax advantages.

Money going into an HSA is tax-deductible (or pre-tax via payroll), it grows tax-free, and withdrawals are tax-free if used for qualified medical expenses. Unused HSA funds roll over indefinitely – effectively, an HSA can act as a secondary retirement account for healthcare in retirement (after age 65 you can even withdraw for non-medical needs, just paying income tax like a traditional IRA, with no penalty).

If you haven’t maxed your HSA, allocating part of your bonus to it lets you immediately reap tax benefits. Unlike 401(k) contributions, HSA contributions made through payroll are exempt from FICA taxes too, saving you that additional 7.65%.

For example, diverting $2,000 of a bonus to your HSA could save you federal and state income tax, plus around $153 in Medicare/Social Security tax that would otherwise be taken out.

The catch: you need to be in an HSA-eligible health plan and you can’t exceed the annual limit. Also, HSAs are individual accounts, not employer-sponsored in quite the same way – you usually set a per-paycheck amount, but you can adjust it to throw in extra from a bonus if you plan ahead.

Choosing the Right Vehicle: Deciding between pumping your bonus into your 401(k) versus an IRA or HSA (or some combination) depends on your circumstances. If your employer offers a 401(k) match, that’s an instant return you don’t want to miss – contributing at least enough to get the full match is priority.

If your bonus is large, you might hit the 401(k) cap; any leftover funds could then go to an IRA or HSA. Also consider liquidity and goals: money in a 401(k) or IRA generally can’t be touched without penalty until age 59½ (with few exceptions), whereas an HSA can be used for medical needs anytime (and after 65 for anything).

Diversifying between these accounts can be wise. For instance, you could put a portion of the bonus in your 401(k) for the immediate tax break and any match, and some in a Roth IRA for tax-free growth on that portion, plus maybe fund your HSA if you have one for the triple tax win.

Just keep contribution limits and eligibility in mind – you can’t exceed them even if you suddenly have a windfall bonus.

Here’s a comparison of key retirement savings options side-by-side, showing how 401(k)s, IRAs, and HSAs stack up:

As the table highlights, 401(k)s allow the most money to be stashed away and often come with free employer money (match), but IRAs and HSAs can play important roles, especially when you want more investment choices (IRA) or flexible medical funds (HSA). A high achiever might use all three: max the 401(k), max the HSA, and throw extra into an IRA or brokerage account.

Courtroom Chronicles: Bonus vs. 401(k) in Legal Battles

Sometimes the intersection of bonuses and 401(k) contributions ends up in court. Understanding these situations provides lessons on how plans should operate and what rights employees have.

Post-Separation Bonus Contributions – ConAgra Brands Lawsuit (2019): One notable case involved a former ConAgra Foods employee who was laid off but later received a bonus that he had partly earned before termination. He had elected to defer 15% of any bonus into his 401(k).

However, ConAgra did not withhold the 401(k) contribution from the bonus paid after his termination, nor did they provide the corresponding employer match. The employee sued, alleging that the plan’s terms defined the bonus as eligible compensation and that ConAgra’s failure to honor his deferral election violated ERISA (the federal law governing retirement plans) and the plan contract.

The crux was a plan interpretation: the company had quietly changed its administrative practice to stop allowing 401(k) deferrals on bonuses paid more than 2½ months after separation without formally amending the plan document.

The case highlighted that employers must follow plan terms strictly or properly amend them – otherwise, employees can claim lost benefits.

While the final outcome of this class-action suit is complex, the lesson is clear: if your plan says a bonus counts for 401(k) contributions, the employer cannot arbitrarily decide not to withhold just because you’ve left the company.

Retention Bonus Not an ERISA Plan – Atkins v. CB&I (5th Cir. 2021): In this case, a group of employees sued over an unpaid project completion bonus (a type of retention bonus) when they quit before the project ended. The employer argued the bonus program was an ERISA-governed plan (which would preempt state wage laws).

However, the court found that a one-time bonus payout for finishing a project did not constitute an ERISA pension plan – it was a simple payroll practice, not an ongoing benefit scheme. Consequently, state law (in this case, Louisiana’s wage law) applied.

Why is this relevant to 401(k)? If an employer tries to label a bonus program as a retirement plan, it might trigger ERISA, but one-time bonuses typically are not ERISA-governed pensions.

More directly, if a bonus isn’t paid due to a condition (like having to be employed on the payout date), there’s no opportunity for 401(k) withholding because the money never actually becomes your compensation.

The case underscores how bonuses are generally kept separate from retirement plan classification – a relief, since we don’t want every bonus program turning into a complicated benefit plan.

It also warns employees that leaving before vesting in a retention bonus can lawfully mean forfeiting it, as long as wage laws are followed.

Clawbacks and 401(k) Contributions: Employers are increasingly including clawback clauses (requiring employees to return bonuses if certain conditions aren’t met), creating a new legal wrinkle. Suppose you got a bonus, invested part of it into your 401(k), and later have to pay that bonus back.

That 401(k) contribution is now problematic – those funds are sitting in your retirement account and legally belong to you, even though you owe money back to your employer. Companies can’t just take money out of your 401(k) to satisfy a debt.

In practice, employers in that situation may request you return the net bonus you received and may write off the 401(k) portion, or they may pursue other legal avenues.

The best preventative measure for employers is to explicitly exclude clawed-back compensation from 401(k) eligible earnings in the plan document, so no contributions are taken from amounts that might be returned.

For employees, it’s a reminder: if your bonus could be clawed back, consider the implications of contributing it to a 401(k). You wouldn’t want to be in a position of repaying money that’s locked in a retirement account.

Any case that does arise in this area will likely hinge on plan language and equitable solutions, but it’s a developing area of law to watch.

Lessons from Litigation: These cases (and potential cases) boil down to a few takeaways.

• First: the plan document’s definition of compensation is king – it governs whether bonuses are included for 401(k) contributions and must be followed to the letter.
• Second: timing matters – whether you’re actively employed or not when the bonus is paid can affect your ability to contribute, and companies must communicate any cutoff policies clearly.
• Third: once bonus money enters a 401(k), it’s generally yours, protected by law, and can’t be taken back without your consent (except to correct errors under strict IRS procedures).

That security is reassuring, but it also means both you and employers should double-check bonus contributions to get them right the first time.

FAQs: 401(k) Withholding on Bonuses

Q: Are 401(k) contributions automatically taken out of bonus checks?
A: Yes. If your 401(k) election applies to bonuses (as it usually does), your chosen percentage will be withheld from your bonus check unless you change your election beforehand.

Q: Can I choose not to contribute to my 401(k) from my bonus?
A: Yes. You can change your 401(k) contribution before the bonus is paid. Many plans let you set a special bonus contribution rate (even 0%) separate from your regular deferral.

Q: Do I pay taxes on a bonus if I put it into a 401(k)?
A: No federal or state income tax is withheld on the portion you put into a traditional 401(k). You still owe Social Security/Medicare on it. Any bonus amount not contributed is taxed as usual.

Q: Will my employer match my 401(k) contributions from a bonus?
A: Usually, yes. If your plan offers matching, contributions from your bonus get matched like any other salary deferral (subject to limits). But some plans exclude bonuses from match or cap the match per paycheck.

Q: Is a signing bonus eligible for 401(k) contributions?
A: Only if you’re eligible for the 401(k) when the signing bonus is paid. If you haven’t entered the plan yet, a signing bonus won’t go in. Once you’re eligible, any later bonus can be contributed.

Q: How much of my bonus can I put into my 401(k)?
A: You can defer up to 100% of your bonus (minus mandatory withholdings like Social Security), unless your plan sets a per-paycheck limit. Just don’t exceed the annual IRS limit for total 401(k) contributions.

Q: Should I put my bonus into a 401(k) or an IRA instead?
A: If your 401(k) isn’t maxed and you get an employer match, prioritize the 401(k). If it’s already maxed or has limited choices, consider putting extra into an IRA (remember the IRA limit is much lower).

Q: Can I contribute my bonus to an HSA?
A: You cannot automatically put bonus pay into an HSA like a 401(k). However, you can contribute some of your bonus to an HSA by adjusting your HSA contributions or depositing it after you get paid.

Q: What happens if I hit the 401(k) limit because of my bonus?
A: If your bonus pushes you over the annual 401(k) limit, the excess gets refunded (and taxed) after year-end. To prevent that, monitor your total contributions and adjust so you don’t exceed the cap.

Q: Are bonuses always considered compensation for retirement plans?
A: Generally yes. Most 401(k) plans treat bonuses as compensation. A plan could specifically exclude certain bonuses (subject to IRS nondiscrimination testing), but that’s uncommon.