Payroll in Practice: 5.20.2024

Question: Lower income employees often complain about an excessive amount of withholding when they receive supplemental wage payments. Some employees turn in new Forms W-4 claiming exempt from withholding when a supplemental wage payment is anticipated. Is there an allowable method that can be used to withhold a lesser amount when supplemental wages are paid?

Answer: Federal regulations provide several procedures for computing withholding. The basic methods are the percentage and wage bracket methods. Alternative methods include the cumulative wage, average estimated wages, part-year employment, annualized wage, and other methods. The cumulative wage method and average wage methods may provide more appropriate withholding for supplemental payments than the standard supplemental wage methods. There is also a special rule that can be used to compute withholding on supplemental pay when there is no withholding from the employee’s regular pay.

The part-year employment method is limited as to when it may be used. The annualized wage method computes the same amount of withholding for a given pay period as the percentage method. Other methods may be used as long as the amount of tax withheld is consistently about the same as it would be under the percentage method.

Supplemental wages are defined in the regulations as wages that are not regular wages. Regular wages are amounts paid at regular rates on an hourly, daily, or other basis and include any predetermined fixed determinable amount for the current payroll period. Supplemental wages vary from payroll period to payroll period, overlap payroll periods, or are paid without regard to the payroll period. They include commissions, bonuses, deferred compensation, severance pay, and non-cash fringe benefits. Employers may choose to treat tips and overtime pay as either supplemental wages or regular wages.

The regulation outlines four procedures that may be used for withholding federal income tax when supplemental wages are paid: mandatory flat-rate withholding, the aggregate procedure, the optional flat-rate procedure, and the special rule where aggregate withholding exemption exceeds wages paid.

Mandatory flat rate withholding at a 37% rate applies to supplemental wages when cumulative supplemental wages paid to an employee during the calendar year exceed $1 million. Generally, it applies only to supplemental wages paid to the employee during the year that exceed the $1 million threshold. However, the employer has the option to withhold 37% from the entire supplemental wage payment that causes the cumulative amount to exceed the threshold. If the mandatory flat rate applies, it must be used on the amount that exceeds $1 million, and any claims on the employee’s Form W-4 are disregarded, including exemption from withholding.

The aggregate procedure may be used for any supplemental wage payment that is not subject to the mandatory flat-rate withholding. Under the aggregate procedure, supplemental wages and regular wages are combined, and total withholding required for the pay period is determined as if the aggregate amount were a single wage payment for the pay period. If more than one payment is made during the pay period, withholding is computed by subtracting amounts withheld or to be withheld from regular pay or earlier payments from the calculated aggregate withholding to determine the amount to withhold from the supplemental or subsequent payments.

The optional flat rate procedure may be used only if three conditions are met:

• The mandatory flat rate does not apply to the payment or portion of the payment.
• The supplemental wages are either not paid concurrently with regular wages or are separately stated on the payroll records of the employer.
• Income tax has been withheld from the employee’s regular wages during the calendar year of the payment or the preceding calendar year.

The optional flat-rate procedure applies a 22% flat rate to the gross supplemental wages. No other rate may be applied when using the optional flat-rate method. The employer’s usual withholding method applies to the regular pay.

The last alternative procedure, known as the special rule where aggregate withholding exceeds wages paid, may provide relief for some lower-income employees. The special rule applies when supplemental pay covers two or more consecutive pay periods, the pay period is not less than one week, the employee receives other wages during these pay periods, no tax is withheld from regular pay, and the amount that is not subject to withholding exceeds the employee’s regular pay for the period.

To determine the amount to withhold from the supplemental pay, an employer must add the regular pay and supplemental wages for the pay periods covered and divide the sum by the number of pay periods. This will calculate the average wage for each pay period, from which the employer must then calculate withholding for each pay period.

After determining the average amount of withholding required for each pay period, multiply that amount by the number of pay periods to determine the total aggregate withholding. Finally, subtract any tax already withheld or to be withheld from payments included in the aggregate wages from the total aggregate withholding to determine the amount to withhold from the supplemental pay.

For example, assume an employee with a semimonthly pay period receives $1,350 per pay period from which no income tax is withheld, In one particular pay period, the employee receives a $3,600 quarterly bonus. The employee’s W-4 indicates “Married filing jointly or Qualifying surviving spouse” in Step 1(c) and a $500 tax credit in Step 3. There are no entries in Steps 2 or 4.

Using the special rule, the $3,600 quarterly bonus would equate to an additional $600 for each of the six semimonthly pay periods covered by the bonus. The average wage per pay period would be $1,950 ($1,350 + $600). This would result in $52.47 of withholding per pay period using the percentage method, or $314.82 in total withholding ($52.47 × six semimonthly pay periods).

For comparison, the withholding would be $792 using the optional flat rate procedure ($3,600 × 22%) and $407.81 using the aggregate procedure and percentage method.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., or its owners.

Author Information
Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

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