Supplemental pay is additional income an employee receives on top of their regular monthly wages or salary.
It’s also referred to as supplemental income.
What does supplemental pay include in the United States?
There are many forms of compensation that typically account for supplemental wage payments. According to the IRS publication 15 (Circular E) on supplemental wages, supplemental wages include:
Accumulated and unused sick leave
Taxable fringe benefits
Retroactive pay increases
However, this is not an exhaustive list, and employers may choose to include additional forms of supplemental pay.
Supplemental wages vs. regular wages
Supplemental wages differ from regular wages in regards to payment dynamics, the tax rate applied, and tax reporting.
While regular wages are tied to a specific payroll period and typically paid on a monthly basis, supplemental wages can be paid regardless of the pay period. For example, an employer may choose to pay out quarterly or lump-sum bonuses or support an employee who moves for work by covering nondeductible moving expenses in a single payment.
Mandatory vs. non-mandatory
An employee’s regular wages are mandatory, but supplemental wages are not. It’s up to the employer to determine what type of supplemental pay they include within their compensation plan.
In addition, rules on supplemental wages differ from state to state. While some types of supplemental pay might be mandatory in one state, they may not be required in another state, but rather the employment contract would define its scope. For instance, severance pay is not mandatory across the United States, but some employees may choose to include it in their standard remuneration offering.
US tax rates for supplemental wages
The IRS rules define two different tax brackets for supplemental wages that employers need to consider:
Supplemental wages above $1 million
When an employee receives supplemental wages of over $1 million in one calendar year, the tax rate applied is 37%. For the excess amount of reimbursements to the employee beyond $1 million, withholding is at 37%. This rate applies regardless of the employee’s Form W-4 (federal income tax withholding).
To properly calculate an employee’s supplemental income, the employer needs to consider supplemental wages paid by all entities that are under common control, i.e., all businesses treated as a single employer.
Supplemental wages below or equal to $1 million
In the second scenario, when supplemental income is below $1 million per calendar year, two main methods apply:
Percentage method—when you apply a flat rate to supplemental income
Aggregate method—when you combine supplemental and regular wages
However, in addition to this broad distinction, the IRS gives a set of steps for a couple of specific scenarios, so let’s have a look at each of them.
Supplemental income is combined with regular pay
If you combine employees’ supplemental income and regular wages without clearly stating the amount of each, then you should withhold federal income tax, whereby the total amount of these two types of wages is considered a single payment for a regular pay period.
Supplemental income is identified separately from regular wages
If you pay supplemental wages separately from regular income, or pay them together but while specifying the amount of each, then working out the tax liability gets a bit more complicated.
If you’ve already withheld income tax from regular wages in the ongoing or previous calendar year, you can apply a flat rate of 22%
If you’re paying out regular income at the same time as the supplemental pay, withhold federal income tax as if the total amount was a single payment for a regular pay period
If you want to pay out the supplemental wages to your employee but there are no concurrently paid regular wages, add the supplemental wages to either the regular wages for the current or previous pay period
If you’re planning to pay more than one type of supplemental wage during a single payroll period, aggregate all the supplemental wages for that period together with regular income, calculate the amount of taxes due for the total figure, subtract the amount of tax already withheld for both the regular wages and supplemental wages, and withhold the remaining tax
No matter which method you use to withhold the federal income tax, they are subject to social security, Medicare taxes, and FUTA taxes, which you also need to take care of.
Each state can prescribe its own set of supplemental tax rates paid to the amount of supplemental wages, which can vary based on the type of supplemental income. For instance, in California, the tax rate applied on supplemental pay is 6.60%, but in the case of stock options and bonuses, it is 10.23%.
Supplemental pay and tax compliance
Withholding taxes for supplemental pay can be a challenge for your compliance efforts, especially if you run a small business. If not done correctly, you risk severe fines and reputational risk. On the other hand, excluding supplemental wages from your employment offers can result in higher turnover, lower productivity, and an overall drop in workforce morale.
It’s best to put an automated payroll solution in place to ensure all exemptions are taken into account, while properly withholding due state income taxes.
Disclaimer: Be aware that this article is not a substitute for tax advice. Please always check official websites or seek professional advice before you take action.