Basically, supplemental wages include a variety of items paid in addition to regular wages. Whereas regular wages constitute straight-time hourly pay or fixed salary, supplemental wages include:
- Back pay.
- Overtime pay.
- Lump-sum vacation payments.
- Retroactive pay increases.
- Severance pay.
- Accumulated sick leave payments.
- Taxable fringe benefits and expense allowances paid via a nonaccountable plan.
- Awards and prizes.
- Reimbursements for nondeductible moving expenses.
Supplemental wages are subject to Social Security tax, Medicare tax, federal income tax, and applicable state and local taxes, and there are some special twists.
Social Security and Medicare taxes. Withhold these two taxes from supplemental wages as you would regular wages.
Federal income tax. If the supplemental wages exceed $1 million for the year, withhold federal income tax on the amount over $1 million at the highest tax bracket of 37 percent. If the supplemental wages are less than $1 million, federal income tax withholding is based on whether the supplemental wages are paid with regular wages.
- If the supplemental wages are combined with regular wages — that is, paid as one amount — withhold federal income tax as you normally would for the regular pay period, using the employee’s Form W-4 and IRS Publication 15.
- If the supplemental wages are paid separately from regular wages and you withheld federal income tax from the employee’s regular wages in the current or prior year, you may withhold federal income tax on supplemental wages at 22 percent. There’s another, more complicated, alternative for withholding federal income tax in this scenario. However, it’s much easier to withhold at the flat percentage.
- If the supplemental wages are paid separately from regular wages and you didn’t withhold federal income tax from the employee’s regular wages in the current or prior year, the more complicated alternative method mentioned above kicks in. This method can be found in the “Supplemental Wages” section of Publication 15.
State and local income taxes. The rules for withholding state income tax from supplemental wages vary by state. For instance, Alabama has a supplemental tax rate of 5 percent. In New York, it’s 9.62 percent. There may also be special rules, depending on the type of supplemental wage. For instance, in California the supplemental tax rate is 6.6 percent, except for bonuses and earnings from stock options — in which case the rate is 10.23 percent.
If the state doesn’t charge an income tax on wages, no state income tax should come out of supplemental wages. Some states, such as Arizona and Connecticut, impose a state income tax but do not have a supplemental withholding rate. In these circumstances, supplemental wages are taxed at the same rate as regular wages are taxed.
If local income tax applies, withhold supplemental wages according to the rules of the local revenue agency. Also note that rates can change frequently, so keep a close eye on state and local rules and regulations.
Be sure to reach out to us if you have any questions about the supplemental wages you pay your employees.