Is Vacation Pay Taxed? Federal and State Rules

Vacation pay is subject to taxation. It is considered a form of compensation, and both federal and state governments treat it as taxable income. This applies whether the vacation time is taken as paid time off or paid out as a lump sum.

Federal Taxation Rules

The Internal Revenue Service (IRS) classifies vacation pay as “supplemental wages,” which are payments an employee receives in addition to their regular wages. Other examples of supplemental wages include bonuses, commissions, and severance pay.

For lump-sum vacation payouts, these are also considered supplemental wages and are subject to federal income tax withholding. Employers have two primary methods for withholding federal income tax on supplemental wages. The first is the percentage method, where the supplemental wages are combined with regular wages, and taxes are withheld as if the total were a single payment for a regular payroll period. The second is the flat rate method, which allows for a flat 22% federal income tax withholding on supplemental wages up to $1 million per year. For supplemental wages exceeding $1 million in a calendar year, the excess amount is subject to a mandatory withholding rate of 37%.

Beyond federal income tax, vacation pay is also subject to Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare. Both the employee and employer contribute to FICA taxes. For Social Security, the employee and employer each pay 6.2% of wages, while for Medicare, each pays 1.45% of wages.

Social Security taxes apply only up to an annual wage base limit, which for 2025 is $176,100. There is no wage base limit for Medicare taxes; all covered wages are subject to the 1.45% Medicare tax. An additional Medicare tax of 0.9% applies to wages exceeding certain thresholds ($200,000 for single filers, $250,000 for married filing jointly), which is withheld only from the employee’s wages and not matched by the employer. The employer is responsible for withholding all applicable federal taxes from vacation pay before the employee receives it.

State and Local Taxation

Most states that levy an income tax align with federal guidelines, treating vacation pay as taxable income. Vacation pay is subject to state income tax withholding in the same manner as regular wages. The specific state withholding rules for supplemental wages can vary, with some states applying similar methods to the federal aggregate or percentage methods, while others may have their own distinct requirements or flat rates.

Several states do not impose a state income tax, including Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. In these states, vacation pay would not be subject to state income tax withholding.

In addition to state income taxes, some cities or counties impose local income taxes. If an employee resides or works in an area with a local income tax, vacation pay is subject to these taxes as well. The application of these local taxes depends on the specific ordinances and the employee’s work location or residency.

Reporting and Withholding

Vacation pay and the associated taxes withheld are reported on an employee’s Form W-2. The total amount of vacation pay, whether taken as paid time off or received as a payout, is included in Box 1 (Wages, tips, other compensation). Similarly, Social Security wages and Medicare wages, which include vacation pay, are reported in Box 3 and Box 5, respectively.

The federal income tax withheld from vacation pay appears in Box 2 of Form W-2. Social Security tax withheld is shown in Box 4, and Medicare tax withheld is in Box 6. State and local wages and taxes withheld are reported in Boxes 16 through 20, as applicable. Employers are legally obligated to withhold these taxes at the time the vacation pay is disbursed, treating it as part of the employee’s taxable compensation.

The actual amount of tax withheld can be influenced by the employer’s payroll system, the employee’s Form W-4 elections, and whether the vacation pay is integrated into a regular paycheck or issued as a separate lump sum. While employers are responsible for withholding these amounts, the employee’s final tax liability is determined when they file their annual federal and state income tax returns. Any over-withholding may result in a refund, and under-withholding could lead to additional taxes owed.