That year-end bonus you banked last month may have felt both affirming and underwhelming.

December bonuses averaged $2,145 in 2023, down from $2,730 in 2022 and $3,583 in 2019, according to a report released this month by Gusto, a payroll software firm.

Workers reaped smaller year-end bonuses in 2023

Bonus checks are smaller because the job market is relatively stable, the report said, which means employers don’t have to do as much to attract and retain their workers. And employers are feeling the pinch of inflation, just like their employees.

How many workers collected year-end bonuses in 2023 is harder to say.

Roughly 66% of employers awarded some kind of year-end bonus, the lowest share since pre-pandemic 2019, according to a November survey of 202 firms by Challenger, Gray & Christmas.

The end of 2023 found many companies in belt-tightening mode, driven by a sense of “economic softness,” said Andrew Challenger, senior vice president at the career transition firm.

The Gusto report also found fewer workers receiving bonuses. But a third analysis reached the opposite conclusion.

An overwhelming 96% of professional services companies planned to offer year-end bonuses, up from just 57% last year, according to November poll of 1,700 employers by the staffing firm Robert Half.

If you were lucky enough to land a year-end bonus, you need to think now about how the pay bump might affect the taxes you pay in 2024. And if you haven’t already spent the bonus, you need to consider what to do with the extra cash.

First, bear in mind that a large bonus check “can potentially push you into a higher tax bracket,” said Samuel Deane, founder of Deane Wealth Management.

Income tax is progressive: The more you earn, the more tax you pay as a percentage of those earnings. If you earned $75,000 in 2023 and you file taxes as an individual, you will pay a top tax rate of 22% on the portion of your income that exceeded $44,725.

A large year-end bonus could leave you owing the IRS

Bottom line: A generous bonus could mean you will be taxed at a slightly higher overall rate on your 2023 earnings.

Now, you may be wondering whether your employer withheld enough taxes to cover your bonus.

The answer: It depends.

Your employer can choose between two options in withholding taxes on a bonus payment, according to Fidelity.

One is the percentage method: The employer identifies the bonus payment as separate income, triggering a flat withholding rate of 22%.

Or, the employer may have used the aggregate method, lumping the bonus into your regular paycheck and withholding taxes on the full amount, based on the withholding formula you set when you filed a W-4 form.

Either way, the bonus could leave you owing the IRS at tax time.

“Remember that withholdings are meant to be an estimate of how much you’ll owe at the end of the year, not the actual tax itself,” said Eric Bronnenkant, head of tax at Betterment, a financial advisory company.

When you complete your return for 2023, the math will reveal whether you and your employer withheld enough taxes to cover your bonus. If not, you may want to increase your withholding by editing your W-4 form for future years.

How to reduce your tax burden on a year-end bonus

Tax experts recommend several other strategies for reducing your tax burden on a year-end bonus.

Here’s one: Consider working with your employer to delay payment of a bonus until the following year. Deferring the income gives you more time to deal with the tax consequences.

“If your bonus is typically issued before the new year, ask your employer to delay payout until January,” said Tiana Patillo, financial adviser manager at Vanguard.

Another strategy: Max out your annual retirement contributions.

If you have a 401(k) plan, “talk to your plan administrator to find out how much more you can contribute,” said Brian Kearns, a certified financial planner in the Chicago area.

Employees could generally contribute up to $22,500 to a 401(k) in 2023.

If you have an IRA, you can use bonus money to max out your contributions to that account, and you have until April 15 to contribute for 2023. IRA contributions topped out at $6,500 last year, with higher limits for older workers.

You can also reduce your taxable income by contributing to a Health Savings Account, a tax-advantaged component of insurance plans with high deductibles.

You can contribute HSA funds for 2023 until April 15, generally up to a maximum of $3,850 for an individual, $7,750 for a family.

“This is the only true ‘tax-free’ vehicle out there,” Kearns said. “Untaxed going in, untaxed going out, while paying for qualified health care expenses.”

How to spend a year-end bonus. Or not.

And then there’s the question of what to do with your bonus, if you haven’t already spent it.

Ideally, employees “should have a strategy in advance for how they are going to use bonuses,” said Rob Burnette, a financial adviser in Troy, Ohio.

If you are looking for tips on how to spend the money, experts say, you might start by squaring off your debts.

“Pay down any debts, especially those with a high interest rate, like credit cards,” said David Oh, head of tax and estate planning at Arta Finance.

Next, “confirm that you have enough emergency savings,” Oh said. “The general rule of thumb is accumulating three to six months’ worth of funds.”

If you have no debt and sufficient savings, then it might be time to invest.

Income tax filing 2023:Here are 6 tips that will help with returns, deductions, credits

Invest in the stock market with caution, Kearns said. “I’ve been advising clients that many parts of the stock market look ‘perfectly priced,’” meaning that now might not be the best time to buy.

As an alternative to stocks, Kearns recommends short-term Treasury investments. Six-month and one-year securities are yielding interest at an annual rate close to 5%.  

“If rates are cut, you have your higher rate locked in,” Kearns said. And if stock prices go down, “you will get your money back and be able to buy in at lower prices.”