What Is Supplemental Payroll and How Is It Taxed?

Payroll encompasses all financial records of salaries, wages, bonuses, and deductions. Supplemental payroll refers to payments made to employees outside of their regular wages, which receive distinct tax treatment. Understanding the differences between regular and supplemental wages is important for both employers and employees to ensure proper tax withholding and reporting.

Understanding Supplemental Wages

Supplemental wages are payments an employee receives in addition to their regular earnings, such as base salary or hourly pay. Regular wages are typically paid at a consistent rate for a specific payroll period, while supplemental wages are often variable and not part of the standard recurring pay. This distinction is important because the Internal Revenue Service (IRS) has specific rules for withholding taxes from these additional payments.

Common examples of supplemental wages include:

• Bonuses
• Commissions
• Overtime pay (if paid separately from regular wages)
• Accumulated sick or vacation leave paid out as a lump sum
• Severance pay
• Retroactive pay increases
• Taxable fringe benefits

Withholding Taxes on Supplemental Wages

Federal income tax withholding on supplemental wages can be handled using one of two methods: the aggregate method or the percentage method. The choice of method depends on how the supplemental wages are paid in relation to regular wages. Supplemental wages are also subject to Social Security and Medicare taxes (FICA taxes) up to the annual wage limits, as well as applicable state and local taxes.

The aggregate method is used when supplemental wages are combined with regular wages in a single payment. The employer adds the supplemental wages to the regular wages paid for the current or most recent payroll period. The total combined amount is then treated as a single payment, and federal income tax is withheld based on the employee’s Form W-4 and IRS withholding tables. This approach can sometimes lead to higher initial withholding than the employee’s actual tax liability for that pay period, as it might push the combined income into a higher tax bracket temporarily.

Alternatively, the percentage method, also known as the flat rate method, applies when supplemental wages are identified separately from regular wages. For supplemental wages up to $1 million within a calendar year, employers can withhold federal income tax at a flat rate of 22%. This method requires that income tax has been withheld from the employee’s regular wages in the current or immediately preceding calendar year. If an employee receives more than $1 million in supplemental wages during a calendar year, any amount exceeding this threshold is subject to a mandatory flat withholding rate of 37%.

Reporting and Record-Keeping

Employers must accurately report all wages, including supplemental wages, to employees and tax authorities. Supplemental wages are included in an employee’s total taxable wages on their pay stub and on Form W-2, Wage and Tax Statement. These amounts are reported in Box 1 (Wages, Tips, Other Compensation) along with regular wages, and are also included in Box 3 (Social Security wages) and Box 5 (Medicare wages). Form W-2 is due to employees by January 31st of the year following the tax year.

Employers must maintain detailed records related to supplemental wage payments and associated tax withholdings. The IRS generally requires records to be retained for a minimum of four years from the date the tax was due or paid, whichever is later. These records should include:

• Employee names
• Addresses
• Social Security numbers
• Dates of employment
• Amounts and dates of all taxable wage payments
• W-4 forms

Accurate record-keeping is essential for demonstrating compliance with tax regulations and for resolving any discrepancies with tax authorities.