Supplemental income often refers to payments that fall outside a normal paycheck, and many employers treat these amounts as supplemental wages for tax purposes under the internal revenue code. In a payroll context, these payments may be taxed differently from regular income because the IRS separates them from regular wages for income tax withholding.
Employers often explain these rules to help employees understand how federal income tax, state income taxes, and Medicare taxes may apply when they receive income that is paid separately from regular pay.
Correct withholding can support compliance expectations, employee clarity, and year-end accuracy when preparing a tax return or reviewing tax forms like Form W-2, which reports income earned and taxable income for the tax year. Our team at BSI will walk you through how supplemental income is taxed so you can better understand the rules employers often navigate when handling these payments.
Key Takeaways
- Supplemental income includes bonuses, commissions, severance, and other payments that fall outside regular wages.
- The IRS uses separate withholding rules for supplemental wages to keep payroll calculations consistent.
- Employers may withhold using either the 22% flat rate or the aggregate method depending on how the payment is issued.
- Supplemental wages over $1 million require mandatory 37% federal withholding on the excess amount.
- State taxation of supplemental income varies, requiring employers to follow location-specific rules.
- BSI’s payroll tax software automates supplemental wage withholding to keep employers compliant and accurate.
Understanding What Counts as Supplemental Income
Common Types of Supplemental Pay Employers Must Withhold On
Some payments are commonly considered supplemental wages, including bonuses that reward performance or periods where employees generate supplemental income through high productivity. Employers may also treat commissions and overtime pay as supplemental pay because these amounts do not follow a consistent schedule and may increase gross income unexpectedly.
Other examples include retroactive pay increases, severance pay, and certain taxable fringe benefits, all of which are treated as taxable income and require employers to withhold income tax. Items like qualified moving expense reimbursements, certain awards, and other fringe benefits may increase an employee’s ordinary income even when provided as expense reimbursements. In each case, these payments may be considered supplemental income for tax withholding purposes.
How Supplemental Income Differs From Regular Wages
Many employers treat supplemental income differently because the IRS applies different tax rules for supplemental tax calculations. This may involve applying specific tax withholding rates that differ from those used on an employee’s typical wage cycle. Some teams track these amounts separately when paying wages, especially when handling a separate payment for bonuses or commission earnings.
Even though withholding may differ, supplemental payments eventually fall under the same tax bracket and personal income tax rate as primary income and regular income. The IRS emphasizes that supplemental wages are simply a category used for withholding federal income tax purposes, not a different kind of ordinary income.
Federal Taxation of Supplemental Income: Core Rules Employers Must Follow
Why Federal Law Requires Separate Withholding Rules
Federal law distinguishes supplemental wages from regular wages to create consistent national standards for employers who must calculate federal taxes across many forms of compensation. This helps organizations navigate the many situations where employees earn extra money, such as commissions or retroactive pay adjustments, that do not align with normal pay cycles.
These standardized methods help payroll teams manage compensation accurately. Without them, employers could unintentionally apply different tax withholding rates that may conflict with the internal revenue code. Standardization ensures consistency for tax purposes, whether the employee earns wages from work or receives undistributed income from other sources such as rental property or self-employed income.
Overview of Federal Tax Responsibilities for Employers
In many organizations, payroll teams monitor supplemental pay and apply the appropriate withholding method. This includes choosing whether to use the supplemental tax rate, reviewing cumulative net income for the year, and ensuring that federal rules are consistently applied.
Employers must also ensure they correctly withhold federal income tax, social security tax, and Medicare taxes on these payments. Some employers coordinate supplemental pay with regular payroll cycles, while others issue a separate payment. These decisions may affect the withholding itself, especially when calculating total income reported for the year.
Federal Withholding Methods for Supplemental Income
The Flat Rate Method
One method employers may use is the federal flat rate method, where supplemental wages up to $1 million may be withheld at a 22 percent tax rate. This applies when supplemental income is paid separately from regular wages. Some employers find this method helpful because it simplifies how they withhold taxes and reduces confusion during busy pay cycles.
This fixed percentage can also reduce variation in employee paychecks. Payroll teams sometimes apply the flat rate to earnings such as bonuses, commissions, and variable payments tied to production, making it easier to manage tax withholding without recalculating everything using regular wage formulas.
The Aggregate Method
Another option is the aggregate method, where supplemental wages are added to primary income and taxed together as a single payment. This method may trigger higher tax withholding rates temporarily because the combined income appears larger on that paycheck. Employers often use it when the supplemental amount is issued during a normal payroll cycle rather than through a separate payment.
Some teams prefer this method because it mirrors how regular wages are taxed and may provide a more accurate estimate of the employee’s final tax liability. However, because the two amounts are combined, employees may notice higher income tax withholding, especially if they are temporarily pushed into a higher bracket.
Mandatory High-Income Withholding
When an employee receives more than $1 million in supplemental wages during the year, employers must withhold 37 percent of the amount above that threshold under federal law. This mandatory rule often affects executives or high-earning employees whose compensation packages include bonuses, awards, or other considered supplemental income.
This rule helps standardize withholding for high-income individuals regardless of how their compensation is structured. Employers may explain that this withholding is simply a prepayment toward the employee’s eventual tax return, and the final calculation depends on all ordinary income earned during the tax year.
How Supplemental Income Is Ultimately Taxed at Filing
At filing time, supplemental wages are taxed like any other ordinary income based on the employee’s final tax bracket. Even though the IRS uses unique rules for withholding, all income ultimately falls under the same personal income tax rate. This means employees can receive refunds if the earlier withholding exceeded their true tax liability.
Refunds occur when early withholding, whether from the flat rate method or aggregate method, overshoots the final federal income tax due. This often happens when large payments such as severance pay or annual bonuses are withheld at higher rates than needed for the person’s actual bracket.
Balances due can arise if the employee had additional earnings with no withholding, such as self employed income, rental income, or royalty income, which may require estimated tax payments throughout the year. Some employees also owe more tax if they deduct items like mortgage interest or health insurance incorrectly or fail to report all sources of net income.
Special Considerations for Self-Employed Workers and Contractors
When Supplemental Income Does Not Go Through Payroll
Some people earn supplemental income outside the payroll system through side gigs, contract work, or other forms of self-employed activity. These earnings may be self-employment income that is not subject to payroll withholding. Workers handling freelance or consulting projects often receive payments that are not automatically taxed and must manage taxes themselves.
Because these payments are not processed as wages, they are not considered supplemental wages under payroll rules. Instead, they are included as gross income when preparing annual filings. Workers may also handle business income, rental income, or other forms of compensation that fall outside the structure of a traditional employer-employee relationship.
Tax Reporting Responsibilities
Independent contractors typically report their income on Schedule C, which captures net income from self-employment. These individuals may owe self employment tax, including social security and Medicare components, because they must pay self employment tax rather than relying on an employer to cover part of the contributions. These amounts are tied to the worker’s ordinary income for the tax year.
Individuals earning self-employed income may need to make estimated tax payments each quarter to avoid penalties. This includes amounts owed for federal income tax, state taxes, and Medicare taxes. Many rely on a tax professional to determine proper calculations, especially when handling business income or revenue from rental property.
State Taxation of Supplemental Income
Variability Across States
Rules around state income taxes vary widely. Some states apply their own supplemental tax rate, while others follow formulas similar to federal methods. Because states also treat certain fringe benefits and expense reimbursements differently, employers often review each state’s guidance before calculating tax withholding.
This variability means two employees receiving the same supplemental pay may see different amounts withheld depending on where they work or live. States with more complex systems may require employers to run supplemental pay through separate payroll rules.
State Examples to Illustrate Compliance Needs
Some states apply high flat rates to supplemental wages. Others follow the federal structure, using either the flat rate or aggregate method. These differences can affect how much tax is withheld from severance pay, bonuses, or other amounts considered supplemental wages.
Employers must remain compliant with these rules to avoid penalties. Consistent adherence protects both the organization and the employee, especially when dealing with multi-state payroll operations or employees who change states during a tax year.
Why Employers Must Follow State-Specific Requirements
State requirements influence the accuracy of employee paychecks and help ensure compliance with both state taxes and federal taxes. When employers follow these guidelines, they reduce the risk of under-withholding or incorrect reporting of income reported on year-end documents.
Accurate state calculations also reduce the need for amendments and corrections. Teams processing payroll across several jurisdictions often spend extra time ensuring they apply the correct tax withholding rates for each type of supplemental income.
Income That Is Not Considered Taxable Supplemental Income
Supplemental Security Income (SSI)
Supplemental Security Income is not taxable and is not considered supplemental income or considered supplemental wages under the IRS rules for employment compensation. SSI benefits do not count as ordinary income, do not generate taxable income, and do not impact how employers withhold taxes from employee pay.
Some employees confuse SSI with other types of supplemental pay, so employers sometimes clarify that SSI is unrelated to supplemental income tax, federal income tax, or employer payroll systems. This distinction prevents misunderstandings during payroll and the annual filing process.
Simplify Supplemental Income Taxation with BSI’s Payroll Tax Software
Handling supplemental income, like bonuses, commissions, and severance, can quickly complicate your payroll process. From flat-rate withholding to the aggregate method, the tax treatment of these earnings varies, and missteps can lead to compliance issues or costly corrections.
That’s whereBSI comes in. Our payroll tax software, TaxFactory™, TaxProfileFactory™, and ComplianceFactory™, automates the complexity. We calculate accurate tax withholding based on pay type, pay frequency, location, and filing status, while ensuring full compliance with federal, state, and local regulations.
If you’re managing supplemental wages across multiple jurisdictions, contact us today and let BSI streamline your payroll tax process with confidence.
Recap: How Supplemental Income Is Taxed
Accurate withholding on supplemental income protects both employers and employees by reducing compliance risk and helping individuals manage their final tax liability. Understanding how supplemental income is taxed, how to apply methods like the flat rate or aggregate approach, and how federal and state variations apply ensures strong payroll processes.
Key rules such as the 22 percent flat rate, the aggregate method, and the 37 percent threshold matter alongside state variations and self-employment considerations. When employers maintain consistent processes, use reliable payroll systems, and communicate clearly, they can handle supplemental wages confidently while helping employees navigate their personal income tax rate, ordinary income, and overall financial picture.
Need help automating all this complexity? That is where we excel. At BSI, we offer payroll tax software that simplifies compliance, updates rates in real-time, and supports every kind of income, traditional employee, self employed, or somewhere in between. Just reach out to us for more information – we are happy to help!
Disclaimer: The information provided in this article is for informational purposes only and should not be considered accounting, tax, or payroll advice. Always consult a qualified professional for guidance specific to your business or situation.
