“How do I tax supplemental wages?” is a common question among employers who offer bonuses, commissions, overtime, severance, and back pay. These types of payments require extra attention to ensure compliance with federal (and some state) tax regulations.
What you’ll learn
What you’ll learn
Fast facts
- Supplemental wages refer to income beyond an employee’s regular wages, such as bonuses, overtime, commissions
- For an employee who makes over $1 million in supplemental wages during the tax year, the earnings in excess of $1 million are subject to a 37% federal income tax withholding
- For an employee who makes less than $1 million in supplemental wages during the tax year, the IRS allows two approved withholding methods: the aggregate method and the flat rate method
- If you over- or under-withhold taxes for employees, the IRS offers options for correcting the error
This comprehensive guide covers federal supplemental income tax rates, withholding requirements, calculation methods, and state taxation considerations. It is designed to help you address compliance challenges. Read on to avoid common mistakes and stay in Uncle Sam’s good graces.
Common types of supplemental wages
Supplemental wages are a broad class of compensation that extends beyond regular wages. They include bonus pay, commissions, overtime, back pay, and severance. This compensation, whether distributed via a single payment or series of payments, is taxed differently than regular wages.
“For regular wages, employees influence how much federal income tax is withheld from their pay (via Form W-4). Conversely, for supplemental wages, the federal government dictates how federal income tax is to be withheld.”
— Tom Brock, CPA, CFA
Before discussing the federal withholding rules, let’s examine the various types of supplemental wages.
Bonuses and commissions
Bonus payments and commissions, which are often collectively referred to as incentive pay or discretionary compensation, are common types of supplemental wages that can comprise a large portion of a business’ budget. Incentive compensation rewards employees for achieving strategic objectives and exhibiting above-average performance.
Severance and back pay
Severance pay is compensation provided to an employee upon termination. Generally, it results from strategic downsizing endeavors and unexpected layoffs. Payment amounts usually vary based on tenure. Back pay is compensation provided for previously performed work. Essentially, it reflects full or partial settlement of an employer-to-employee financial obligation for labor rendered.
Overtime
Overtime is compensation provided to employees that work in excess of regular hours, which is typically represented by a 40-hour workweek. It is usually calculated at a rate of one and one-half times an employee’s regular hourly rate of pay.
Whether your business provides one or all of these supplemental wages, you need to take special measures to ensure your payroll is administered properly. This entails withholding the appropriate amounts from employees’ checks, remitting withholdings to the government, and generating the required regulatory forms and supplemental reports.
Now that we know which wages count as supplemental, let’s talk about how to withhold taxes without raising the ire of Uncle Sam.
IRS-approved methods for withholding taxes
For an employee who makes over $1 million in supplemental wages during the tax year, the earnings in excess of $1 million are subject to a 37% federal income tax withholding. The 37% withholding is mandatory, even if the employee submitted a Form W-4 claiming exemption from federal income tax.
For an employee who makes less than $1 million in supplemental wages during the tax year, the IRS offers two primary methods for withholding taxes: the aggregate method and the flat rate method. The aggregate method is more complex than the flat rate method, but it can yield more accurate withholdings when administered properly.
The aggregate method
- When to use it: The aggregate method is utilized when an employer combines regular wages with supplemental wages in a single paycheck and the amount of each type of payment is not specified.
- How it works: With the aggregate method, you should withhold federal income tax as you normally would. In other words, calculate withholding for the total payment using the employee’s Form W-4.
Common mistakes
“With the aggregate method, mistakes usually result from incorrect processing of the information on an employee’s Form W-4. As a result, it’s critical to handle these forms with a high degree of attentiveness and, when applicable, to verify the information loaded into your payroll software.”
— Tom Brock, CPA, CFA
The flat rate method
- When to use it: The flat rate method can be utilized when an employer pays supplemental wages separately from regular wages and/or tracks each type of payment distinctly.
- How it works: For the flat rate method, a fixed 22% is applied to the supplemental wages. However, as indicated previously, if an employee’s supplemental wages exceed $1 million, the rate is increased to 37%. For example, let’s say one of your team members earns a $4,000 year-end bonus for a job performance far exceeds expectations. With the flat rate method, you would withhold $880 from that team member’s paycheck ($4,000 x 0.22 = $880) for the supplemental income earned.
Common mistakes
“Some businesses fail to properly distinguish between regular and supplemental wages, which can result in incorrect withholding. The flat rate method can only be used if the two types of wages have been segregated.”
— Tom Brock, CPA, CFA
An employer can use either the aggregate method or the flat rate method to fulfill its federal income tax withholding responsibility. The former method is generally used by employers that administer payroll using sophisticated software, while the latter method is more often embraced by employers that maintain manual or semi-manual payroll processes.
The aggregate method and the flat rate method both pertain to federal income tax withholdings, but an employer’s tax withholding responsibilities extend further. Employers must also facilitate withholdings for state and local income taxes and Social Security and Medicare taxes.
Regardless of the method to manage this, an employer should openly communicate the federal government’s withholding requirements for supplemental wages to its employees. This can mitigate the potential for disappointment and/or confusion when payments are distributed.
Correcting over- or under-withholding errors
The bad news is that mistakes will happen. The good news is that your business has several options for correcting both over-withholding and under-withholding errors. You use Form 941-X to make corrections. As a general rule, you can update federal income tax withholding errors that are found in the same calendar year as the wages were paid.
For over-withholding, you can correct the error if and only if you reimbursed your employee in that same year. You can choose to refund the excess amount to the employee through your payroll system or adjust future paychecks accordingly. For under-withholding, you can adjust the employee’s withholding amount in subsequent pay periods.
If you have significant issues with over- or under-withholding or are unsure about your business’s filing status, it is a good idea to consult with a tax advisor. They can help you make sense of things and avoid future withholding complications.
“OnPay is the best online resource for payroll. Their customer service is fast and responsive, and the platform offers tremendous flexibility in how people are paid—whether hourly, tips, bonuses, or commissions. The fully automated tax calculation and payment to the correct government agencies means OnPay lets me focus on running my business instead of spending countless hours trying to ensure my payroll is done correctly.”
— David Mazaika, Coulomb Solutions Inc
State-specific rules and considerations
Some states have unique rules and regulations regarding withholdings for supplemental wages, and some do not even impose an income tax. In Florida, Texas, and Washington, for instance, you only need to withhold federal income taxes. California applies a flat rate of 10.23% for bonuses and stock options, but uses a rate of 6.6% for other forms of supplemental wages. Oregon uses an 8% flat rate on all forms of supplemental income.
These are just a handful of examples. It is essential to understand state-specific tax regulations wherever you do business and to implement measures and controls to ensure compliance.
Takeaway: Understanding taxing supplemental wages makes good business sense
Compensating team members with supplemental wages can increase motivation, boost performance, and facilitate the long-term growth of your company. However, remember, when staffers receive bonuses and other types of supplemental wages, you need to make sure to withhold the appropriate, IRS-stipulated amount of federal income tax. Partnering with a reputable payroll software company, such as OnPay, can help you reward your employees without exposing your business to administrative hassles and compliance issues. Contact OnPay today to get started, trial our software for 30 days, and find out how we can support your business.
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Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.