What Are Supplemental Wages and How Are They Taxed?

Supplemental wages are compensation distinct from an employee’s regular salary or hourly wages. These are additional forms of remuneration, not part of standard fixed earnings. Understanding how supplemental wages are taxed is important for both employers and employees.

Understanding Supplemental Wages

Supplemental wages are payments made to an employee beyond their regular salary or hourly wages. They are typically irregular, not paid at a consistent rate for a regular payroll period.

Common examples of supplemental wages include bonuses, commissions, and overtime pay. Other forms can involve payments for accumulated sick leave, severance pay upon termination, cash awards or prizes, retroactive pay increases, back pay, certain taxable fringe benefits, and non-deductible moving expense reimbursements.

The distinction between supplemental and regular wages affects how federal income taxes are withheld. Unlike regular wages, supplemental wages do not necessarily adhere to an employee’s payroll period. For instance, a bonus might be paid as a one-time lump sum outside of the normal pay cycle, requiring different withholding rules.

Some payments, like overtime pay and tips, may be treated as supplemental wages, though employers can sometimes treat them as regular wages. If unused PTO or vacation hours are paid out as a lump sum, they are classified as supplemental.

Taxation Methods for Supplemental Wages

The Internal Revenue Service provides specific methods for employers to withhold federal income tax from supplemental wage payments. The chosen method often depends on how the wages are paid and the total amount involved.

One common approach is the Percentage Method, also known as the Flat Rate Method. This method is used when supplemental wages are paid separately from regular wages or clearly identified on a pay stub. For supplemental wages up to $1 million paid to an employee within a calendar year, federal income tax is withheld at a flat rate of 22%.

For supplemental wages exceeding $1 million within a calendar year, a different rule applies. Any amount over the $1 million threshold is subject to a mandatory withholding rate of 37%. This higher rate corresponds to the highest income tax rate under federal law and is mandatory regardless of the employee’s Form W-4.

The second primary method is the Aggregate Method. This method is applied when supplemental wages are combined with regular wages into a single payment, and the individual amounts are not separately identified. Under the aggregate method, the supplemental wages are added to the employee’s regular wages for the current or most recent payroll period. The total combined amount is then treated as a single wage payment for that payroll period.

The employer then calculates the withholding amount using the employee’s Form W-4 and the appropriate IRS withholding tables, as if it were a single regular payment. After determining the total tax on the combined amount, any tax already withheld from the regular wages is subtracted, and the remaining tax is withheld from the supplemental portion. Supplemental wages are also subject to Social Security and Medicare taxes, just like regular wages.

Employer and Employee Responsibilities

Employers are responsible for correctly classifying supplemental wages and applying the appropriate federal income tax withholding method. Proper record-keeping is essential to track all supplemental payments made to each employee, especially for determining if the $1 million threshold for the higher withholding rate is met. All wages, including supplemental wages, must be reported on an employee’s Form W-2 at the end of the tax year.

For employees, understanding how supplemental wages are taxed can prevent surprises at tax time. A higher percentage might be withheld from supplemental payments compared to regular pay, often due to the flat 22% rate. Employees should know that this withholding is an estimate; their actual tax liability is determined when they file their annual tax return.

All supplemental wages are included in an employee’s total taxable income for the year and reported on their Form W-2. When preparing annual tax returns, these wages are combined with all other income to calculate total tax liability.

The tax withheld from supplemental wages, along with regular wages, is credited against this total liability. If too much tax was withheld, the employee receives a refund; if too little, they owe additional tax. Employees can use the IRS Tax Withholding Estimator to adjust their Form W-4.