Cash bonuses paid by employers to employees for performance, achievement or service are taxable just like wages are. It’s important for a payroll manager to be aware of this and to comply with tax withholding laws when disbursing bonus checks. As with regular wages, withholding and remitting too little from bonus payments can result in serious IRS penalties.
The Internal Revenue Service classifies bonus payments in the category of “supplemental wages,” which also covers a wide range of payments that fall outside of basic employee payroll, such as commissions, overtime pay, payments for accumulated sick or vacation leave, severance pay, awards, prizes, back pay and retroactive pay increases.
Employees receiving a bonus for the first time may not even be aware that the money is taxable. Others may be taken aback when by the amount of the withholding, which may be disproportionately large compared to the deductions from their regular checks. Some employees may believe that their payroll processor has made an error. Others may draw the common but mistaken conclusion that the IRS taxes bonus pay at a higher rate than regular wages.
Payroll administrators may be well advised to clear up employee confusion on that last point. Ultimately, employees’ bonuses will be taxed at the same rate as the rest of their wages, which will be determined by the tax bracket they fall in based on their total income for the year. However, federal income tax may initially be withheld from the bonus payment at higher rate. At tax time, any net overpayment will be returned by the IRS in the form of a refund.
IRS regulations give different options for withholding income tax from bonus payments to employees, except for the very largest bonuses. Bonuses to an employee totaling more than $1 million in a year automatically incur a 35% federal income tax withholding. Anything less than that can be treated one of several ways:
- Combine the bonus along with that pay period’s regular wages and calculate withholding based on the total
- Identify the regular and supplemental wages separately and withhold a flat 25 percent from the supplemental wages
- Identify the regular and supplemental wages separately. Calculate withholding based on just the regular wages and withhold that amount from regular wages. Then calculate withholding based on the total amount. Subtract the first number from the second number, and withhold this amount from the supplemental wage portion of the employee’s pay.
It’s not hard to see why these methods can create the false impression among employees that their bonus is money is being subject to some kind of “special” tax. The 25 percent rate is higher than many employees’ regular withholding rate. With the other two methods, employees may “temporarily” be elevated into a higher tax bracket, because payroll systems usually annualize each pay period’s earnings for tax calculation purposes.
Take an example of an employee who normally earns $1,000 per week ($52,000 a year). Say he or she gets a $2,000 bonus the last week in December. The bonus actually increases the employee’s income for the year by less than 4 percent, but as a lump sum payment it triples their wages for the last pay period. Thus, withholding on that last check is calculated as if the employee had earned $156,000 for the year. Portions of that check will be subject to much higher marginal withholding rates of 25 and 28 percent.
Keep in mind that regardless of the method used to withhold income tax on supplemental wages, they are also subject to social security, Medicare, and unemployment insurance withholding. Supplemental wages are subject to any applicable state and local taxes as well. Employees could easily see 40 percent or more of their bonus being withheld, even though they may get a good portion of that back as a refund when they file their tax returns.
Padgett Payroll Services is a small business payroll specialist that can help your company with the complexities of tax and payroll law. Call us today at (706) 548-1040 to learn more about the advantages of payroll outsourcing to Padgett.