In addition to an employee’s regular wages they receive each month, they may also be entitled to additional income, called supplemental pay or supplemental income. While this term is quite broad and can include any additional compensation from tips to back pay, there are a dozen forms of compensation that typically account for supplemental wage payments.
According to the IRS publication 15 (Circular E) on supplemental wages, supplemental wages include:
- Overtime pay
- Accumulated and unused sick leave
- Severance pay
- Vacation pay
- Back pay
- Taxable fringe benefits
- Retroactive pay increases
However, this is not an exhaustive list and employers may choose to include additional forms of supplemental pay.
But while the rule of thumb definition seems simple, managing supplemental pay for your employees properly is quite different in practice, where you need to apply different tax rates and reporting rules to stay compliant and avoid costly mistakes, which can range from a couple of hundreds of dollars to a couple of hundred of thousands of dollars.
So, in this post, we will untangle how supplemental wages work and provide a handy tax guide that shows which supplemental tax rate to apply to various types of supplemental pay, how to properly report tax withholding, and which IRS rules you need to follow.
Supplemental wages differ from regular wages in several aspects — payment dynamics, the tax rate applied, and tax reporting.
While regular wages are tied to a particular payroll period and mostly paid on a monthly basis, supplemental wages can be paid regardless of a payroll period. For example, an employer may choose to pay out quarterly or one-time bonuses or support an employee who moves for work by covering nondeductible moving expenses.
Then, while regular wages are mandatory, supplemental wages are not; it’s up to the employer to determine what type of supplemental pay they will include within their compensation plan.
In addition, rules on supplemental wages differ from state to state. While some types of supplemental pay might be mandatory in one state, they may not be required in another state, but rather the employment contract would define its scope. For instance, severance pay is not mandatory across the US, but some employees may choose to include it in their standard remuneration offering.
The IRS rules define two different tax brackets employers need to consider:
- Amount of employee’s supplemental wages exceeds $1 million per calendar year, in total
- Amount of employee’s supplemental pay is equal to or less than $1 million per calendar year, in total.
Depending on which category an employee’s supplemental income falls under, employers need to apply different withholding rates.
Supplemental wages above $1 million
When an employee receives supplemental wages of over $1 million, the tax rate applied is 37% — which means that for the excess amount of reimbursements to the employee beyond 1$ million withholding is at 37%. This rate applies regardless of the employee’s Form W-4 (federal income tax withholding).
To properly calculate the amount of supplemental income, the employer needs to take into account supplemental wages paid by all entities that classify to be under common control, i.e. all businesses treated as a single employer.
Supplemental wages below or equal to $1 million
In the second scenario, when supplemental income is below $1 million per calendar year, there are two main methods that apply:
- Percentage method — when you apply a flat rate to supplemental income
- Aggregate method — when you combine supplemental and regular wages
However, in addition to this broad distinction, the IRS gives a set of steps for a couple of specific scenarios, so let’s have a look at each of them.
Supplemental income is combined with regular pay
In case you pay supplemental income together with regular wages, without clearly stating the amount of each, then you should withhold federal income tax, whereby the total amount of these two types of wages is considered a single payment for a regular pay period.
Supplemental income is identified separately from regular wages
If you pay supplemental wages separately from regular income, or pay them together but while specifying the amount of each (unlike in the previous case), then working out the tax liability gets a bit more complicated, but follow these steps for easier navigation:
In case you’ve already withheld income tax from regular wages in the ongoing or previous calendar year, then either:
- Apply a flat rate of 22%, or
- If you’re paying out regular income at the same time as the regular pay, then withhold federal income tax as if the total amount was a single payment for a regular pay period (just as in section a) above).
- If you want to pay out the supplemental wages to your employee but there are no concurrently paid regular wages, add the supplemental wages to either the regular wages for the current or previous pay period. In this case, the income tax withholding rate would be calculated as if the regular wages and supplemental wages were treated as one single payment. Then, you can subtract the amount you already withheld or are about to withhold. Finally, you can withhold the amount of renaming tax from the supplemental wages.
- If you’re planning to pay more than one type of supplemental wages during a single payroll period—let’s say that during one payroll period, you’ve already paid out bonuses, but are also planning to pay our accumulated sick leave—then aggregate all the supplemental wages for that period together with regular income, calculate the amount of taxes due for the total figure; then, subtract the amount of tax already withheld for both the regular wages and supplemental wages (i.e. bonuses in our case), and then withhold the remaining tax.
Finally, no matter which method you use to withhold the federal income tax, they are subject to social security, Medicare taxes, and FUTA taxes, which you also need to take care of.
However, in addition to these rates, each state can prescribe its own set of tax rates paid to the amount of supplemental wages, which can vary based on the type of supplemental income. For instance, in California, the tax rate applied on supplemental pay is 6.60% but in the case of stock options and bonuses, is 10.23%.
Withholding taxes for supplemental pay can be a challenge for your compliance efforts, especially if you run a small business. If not done correctly, you’re risking severe fines and reputational risk. On the other hand, choosing to exclude supplemental wages from your employment offers can result in higher turnover, lower productivity, and an overall drop in workforce morale. So, to make the most of it while staying compliant, it’s best to put an automated payroll solution in place. That way, you’ll ensure all the exemptions are taken into account, while properly withholding due income taxes.
Disclaimer: Be aware that this article is not a substitute for tax advice. Please always check official websites or seek professional advice before you take action.