Part 1 of this series explored the difference between supplemental wages and regular wages. Now, in Part 2 of the series, discover some guidelines around calculating the taxes on supplemental wages.
Every employee is entitled to receive compensation for all services rendered. However, some compensation is treated as supplemental wages, and taxes may be withheld differently from regular wages.
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When supplemental wages are paid in the same paycheck as regular wages and the amount of each is not specified, the income tax is calculated the same as regular pay. However, when supplemental wages are paid or identified separately from regular wages, things can get more complex.
Calculating Income Tax
IRS Publication 15 describes several methods of calculating the federal income tax withholding on supplemental wages:
- Combine the supplemental wages with the employee's regular wages, and withhold the federal income tax as if the total were a single payment for a regular payroll period.
- Identify supplemental wages separately from regular wages and withhold a flat 22% (as of 2018).
- Identify supplemental wages separately from regular wages, and calculate the tax withholding.
The first option only applies if supplemental wages are combined with regular wages and there is no specification of the amount of each. The second and third option may only be used if supplemental wages are identified separately from regular wages. This could mean that the supplemental wage is paid separately or along with the regular wages.
How to Determine Taxes on Supplemental Wages
Method 1 - Based on Employee's Form W-4
The first method is relatively simple. This method only can be used when supplemental wages are paid with regular wages and not identified separately on the employee's pay stub.
Most overtime pay, certain taxable fringe benefits (such as group term life insurance), and smaller bonuses typically won't result in an employee's wages being projected into a higher tax bracket, so it may make sense for some employers to use this method.
Method 2 - Withhold a Flat 25%
The second method is the simplest. Employers can withhold a flat 22% — the IRS does not allow any other percentage to be used. For instance, a $2,000 bonus must have $440 deducted in federal taxes.
However, this method can be used only if the employer has withheld income taxes from the “employee's regular wages in the current or immediately preceding calendar year.”
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Method 3 - Complex Calculation
The third method requires a more complex calculation. This method must be used if the employer has “not withheld income tax from the employee's regular wages in the current or immediately preceding calendar year.”
This method requires the following steps:
- Identify the employee's regular wages. This could be the employee's current regular wages, or the regular wages paid for the previous payroll period if there are no current wages.
- Add the supplemental wages to the regular wages and calculate the tax withholding on the combined amount based on the employee's Form W-4.
- Determine the federal income tax withholding from the combined wages (regular wages + supplemental wages).
- Identify the amount withheld from wages on the most recent pay date that only had regular wages and subtract this amount from the combined withholding amount.
- Withhold the difference between the combined withholding amount and the withholding on the most recent pay date that only had regular wages from the employee's supplemental income.
There is one major exception to the above rules. If an employee receives more than $1 million of supplemental wages during the calendar year, then any supplemental wages paid in excess of $1 million are “subject to withholding at the rate of 37% (or the highest rate of income tax for the year).”
In addition to federal income taxes on supplemental wages, many states also have rules for withholding state income taxes on supplemental wages, so each employer is obligated to check state rules as well.
Meeting the Right Conditions
As a reminder, under certain circumstances you must use one of the three options above, or you may be precluded from using one of the above methods.
We hope this guide makes it easier to differentiate between supplemental and regular wage payments, helping you to pay your team with confidence.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.