Every employee is entitled to receive compensation for all services rendered. However, some compensation is treated as supplemental wages, and taxes withheld may be different from taxes withheld from regular wages.
Simply put, supplemental wages are wage payments other than regular wages. There are many different types of supplemental wages (more on this below), and these are taxed differently than regular wages, which is why it’s important to distinguish between what’s supplemental vs. regular wages to employees.
The IRS requires a certain amount of supplemental income tax to be withheld under section 3402 of the Internal Revenue Code.
Supplemental wages span many various types of payments. Some examples of supplemental wages include:
Overtime pay (if paid separately from regular wages)
Payments for accumulated sick leave
Reported tips (if paid separately from regular wages)
Awards, prizes, and bonuses
Retroactive pay increases
Payments for nondeductible moving expenses
Taxable fringe benefits and expense allowances paid under a non-accountable plan
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 2023).
If the supplemental wages are paid concurrently with regular wages, add the supplemental wages to the concurrently paid regular wages and calculate the tax withholding. You’ll add the wages together and withhold federal income tax as iif the total of the regular wages and supplemental wages is a single payment for a regular payroll period. We’ll break down every step down below.
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.
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.
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.”
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.
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.
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