How Is a PTO Payout Taxed Differently?

Paid Time Off (PTO) payout is the payment an employee receives for unused accrued vacation, sick, or personal leave time, usually upon termination of employment. While policies vary by employer and jurisdiction, accumulated and unused PTO balances may be paid out when an employee leaves a company. This payout is considered taxable income, similar to regular wages.

How PTO Payouts Are Taxed

PTO payouts are treated as ordinary income for federal tax purposes, subject to the same federal income tax rates as an employee’s regular wages. The Internal Revenue Service (IRS) considers these amounts compensation for services, with no special or reduced tax rate applied.

These payouts are also subject to Federal Insurance Contributions Act (FICA) taxes, including Social Security and Medicare. The Social Security tax rate is 6.2% for both employee and employer, up to an annual wage base limit ($168,600 for 2024). The Medicare tax rate is 1.45% for both employee and employer on all wages, with no wage base limit. An additional Medicare tax of 0.9% may apply to individual earnings over $200,000, or $250,000 for married couples filing jointly, paid solely by the employee.

Understanding Withholding and Reporting

Employers withhold federal income tax, Social Security tax, and Medicare tax from PTO payouts. For federal income tax withholding, PTO payouts are categorized as “supplemental wages.” The IRS defines supplemental wages as compensation paid in addition to regular wages, such as bonuses, commissions, and severance pay.

Employers use two primary methods for withholding federal income tax from supplemental wages. The first is a flat rate withholding of 22%, which applies if supplemental wages, including PTO payouts, are separately stated or exceed $1,000,000 in a calendar year. The second is the aggregate method, which combines supplemental wages with regular wages for the current or most recent payroll period. Tax is then withheld as if the total were a single payment. Regardless of the withholding method, the full amount of the PTO payout, along with other compensation, is reported on an employee’s Form W-2, Wage and Tax Statement, in Box 1 for wages, tips, and other compensation.

State and Local Tax Considerations

Beyond federal taxes, PTO payouts are subject to state income taxes in jurisdictions that impose them. Most states with an income tax treat PTO payouts as taxable income, similar to regular wages. State tax rates and rules vary significantly across the United States.

Some states do not impose state income tax, so PTO payouts are not subject to state-level taxation there. Additionally, certain cities or counties may levy local income taxes on wages, which could apply to PTO payouts based on local tax laws. The overall tax impact of a PTO payout can differ based on an employee’s state and local tax residency.

References

1. Topic No. 751 Social Security and Medicare Withholding Rates. Internal Revenue Service. https://www.irs.gov/taxtopics/tc751
2. Publication 15, (Circular E), Employer’s Tax Guide. Internal Revenue Service. https://www.irs.gov/pub/irs-pdf/p15.pdf