Bonus payments are treated differently from regular wages for tax purposes. The IRS classifies bonuses as supplemental wages and provides specific guidelines for their taxation. Generally, you have two main options: withhold a flat 22% for federal income tax (for bonuses up to $1 million), or combine the bonus with regular wages and calculate withholding as if it were a single larger paycheck.
The distinction between regular and supplemental earnings is key to understanding how this works, so let’s dive into that first.
Regular vs Supplemental Wages
Regular earnings and supplemental earnings are two distinct types of compensation that employees may receive, each with different tax implications.
Regular earnings, also known as regular wages, are the predetermined amounts paid to an employee for their standard work hours or salary, typically on a consistent schedule. These are subject to standard income tax withholding based on the employee's W-4 form.
Supplemental earnings, on the other hand, are additional payments made outside of regular wages, such as bonuses, commissions, overtime pay, severance, and certain fringe benefits. The IRS treats supplemental wages differently for tax purposes, often applying a flat withholding rate of 22% (for amounts up to $1 million annually).
When a payroll includes BOTH types of earnings, The IRS allows employers to aggregate supplemental wages with regular wages for withholding calculations. This distinction is important for both employers and employees to understand, as it affects payroll processing, tax withholding, and potentially an individual's overall tax liability.
When the Paycheck includes regular earnings
When the paycheck includes at least some regular earnings, then Eddy applies the Aggregate Method.
In this method, Eddy combines the bonus with regular wages and withholds as if the total were a single payment for the regular payroll period. This can result in more accurate withholding for employees whose regular income places them in a higher tax bracket. In this method, supplemental wages are added to the employee's regular wages and the total amount is subject to the normal tax withholding process.
Example:
- Jake is paid weekly at an hourly rate of $25 per hour. Jake works 32 hours and takes 8 hours of sick time. In this scenario, Jake's pay received for sick time is included as part of his regular wages.
- Jake's sick time is considered supplemental wages and his employee will add the pay for sick time to Jake's regular wages to be taxed based on the elections on his Form W4.
When the paycheck does NOT include regular earnings
When a paycheck does not include any regular earnings, the recommended option is to apply the Standard Withholding Method (Flat rate). The IRS provides this standard method for withholding taxes on supplemental wages:
- For supplemental wages up to $1 million, the flat withholding rate is 22% for federal income tax.
- For amounts exceeding $1 million in a calendar year, the withholding rate is 37% for the portion above $1 million.
This method is used in Eddy in an off-cycle payroll where no regular earnings are included. A flat percentage is applied to the supplemental wages. As of the current tax guidelines (2024) this flat rate is typically 22%.
Example:
- Mindy is a sales representative paid a bi-weekly salary of $2,500 per pay period which equates to $65,000 per year. Mindy earns a commission for each sale as well as a quarterly bonus if she meets her sales quotas.
- Commissions and bonuses at her company are paid on off-cycle payrolls and are not included as regular wages.
- Mindy's employer taxes commissions and bonuses at the IRS recommended supplemental rate of 22% for federal income tax.
How to select the method in Eddy
To select the appropriate method in an off-cycle payroll in Eddy, start by clicking the Run Off-cycle payroll button. You’ll see an option to select How should this payroll be taxed. If the payroll includes regular earnings, then choose the regular frequency of your pay periods (weekly, biweekly, etc.). If the payroll does not include any regular earnings, then choose the supplemental option.
Best Practices for Payroll Specialists
By following these best practices, payroll specialists can maintain accuracy, build trust with employees, and protect the company from potential financial and legal risks associated with payroll errors. Ultimately, these practices contribute to a smoother payroll process, reduced stress during tax season, and a more informed and content workforce.
- Consistency: Decide how and when you’ll mark a payroll as supplemental and use it consistently across the organization. This helps ensure fairness and reduces the likelihood of employee complaints or confusion.
- Compliance: Stay updated on federal and state tax regulations. The IRS updates Publication 15 (Circular E) annually with the latest rates and rules. Staying compliant with ever-changing federal and state tax regulations is essential to avoid costly penalties and legal issues.
- Education: Help employees understand how their bonuses are taxed and what options they may have. Educating employees about bonus taxation helps manage expectations and improves overall satisfaction.