Understanding Supplemental Pay: Examples, Exclusions, Taxation & More

Supplemental pay is a term used to describe additional income granted to employees. It includes bonuses, overtime compensation, and other types of payment given on top of employees’ regular pay.

It is essential to understand the full definition of supplemental pay and distinguish between the different types of additional compensation.

Keep reading if you want to learn more about supplemental pay, its tax implications, and how to implement it effectively for your employees.

Key Takeaways

• Supplemental pay is any additional payment given on top of a worker's regular income. The most common examples include bonuses, overtime pay, tips, and commissions.
• Regular wages refer to the employees’ fixed income, which is based on their standard or hourly rates. In contrast to supplemental pay, regular wages are paid every payday.
• Employers must impose a 22% flat tax rate on supplemental wages paid separately from their staff’s regular pay. Otherwise, they may withhold a 37% tax rate if the additional income exceeds $1,000,000.
• Stipends, vacation pay, and paid time off do not qualify as supplemental pay since the payments are typically included in employees’ regular income.

What is Supplemental Pay?

Supplemental pay is usually a cash-based payment given to employees apart from their regular wages or salaries. Other terms that have the same meaning as supplemental pay include supplemental income or wage, side income, additional pay, or extra commission.

Bonuses, overtime pay, and commissions are some of the most common examples of this type of compensation. At the same time, supplemental pay applies when employers adjust an employee’s salary or provide the final payment for terminated workers.

It is important to note that workers and independent contractors can both receive supplemental income.

Business owners may also receive supplemental income, particularly through money acquired from estates, royalties, residual interests, partnerships, S corporations, and trusts.

From an employee’s perspective, employers grant supplemental wages to reward and motivate employees, compensate for extra work hours, and acknowledge their hard work for hitting specific metrics in their performance.

The tips that service industry workers receive from customers are likewise considered supplemental compensation.

Regardless of which supplemental pay employees receive, employers must see to it that all additional income is reflected on their employees’ paycheck records for transparency and accounting purposes.

Supplemental Wage vs. Regular Wages

The critical distinction between supplemental and regular wages is that employees only receive supplemental wages once they meet the conditions proportional to the additional income they are granted.

Below are a few more factors that help differentiate regular income from supplemental or side income:

Payout

In contrast to the proportionality mentioned above, regular wages are fixed payments disbursed to employees every scheduled payday. Employers pay regular wages regardless of whether their staff qualify for any type of supplemental compensation or not.

Tax Rates

Another significant difference between the two types of wages is how the IRS imposes taxes on each. The IRS follows a flat rate of 25% when imposing taxes on supplemental income.

Meanwhile, regular wage tax rates are based on the workers’ tax bracket and filing status. It is calculated using the percentage method.

Reporting

Employers use Box 1 of Form W-2 to report their personnel’s total regular wages, which includes their withheld taxes and other types of compensation.

Employers can also use Box 1 of Form W-2 to report supplemental income and declare it part of employees’ regular wages.

However, independent contractors and employees who earn side income outside their regular jobs may use Schedule C of Form 1040 to report their extra earnings.

What Qualifies as Supplemental Pay?

Employers typically use pay stub abbreviations such as COMM (Commission), BON (Bonus pay), Severanc (Severance Pay), and OT (Overtime Pay) to indicate the supplemental wages paid to an employee for a specific pay period.

To help you identify what qualifies as supplemental pay with ease, below are common supplemental pay examples and their definition:

#1. Bonuses

Bonuses refer to incentives or payment rewards given to employees for their commendable work performance.

Other instances where employers grant bonuses include when employees refer new applicants to join the company, reach a certain number of years of service in their tenure, or recently join the team as a new employee.

#2. Tips

This type of supplemental wage is more common in the service industry. Hotel staff, bartenders, restaurant servers, delivery drivers, and tour guides heavily depend on tips to increase their earnings.

Tipping is also a way for customers to express how happy and satisfied they are with the service. In the U.S., the tipping culture is more prevalent than in other countries, although the underlying reasons for the tip vary among Americans.

#3. Overtime

Overtime pay is given when employees or workers exceed their allotted or regular weekly work hours. Note that all non-exempt employees are entitled to receive overtime compensation, according to the FLSA.

#4. Commissions

The sales industry is known for granting commissions to its employees. An example of commission-based pay involves paying sales representatives a portion of the company’s total sales or the percentage of the sales they made themselves when they hit their quotas.

#5. Severance

Severance pay, or severance package, is the final payment given to employees when they leave their position in the company. This supplemental pay will assist terminated employees transitioning to a new workplace.

Employers usually calculate and plan the company’s severance package, considering the employee’s unpaid salary from the last pay period, their position and tenure, and the reason behind their termination.

#6. Retroactive Pay Increases

Employees receive retroactive or retro pay whenever certain adjustments are made to their last salary. For example, they received compensation that only partially reflected the work hours they completed since the previous pay period.

Other examples of retroactive pay include salary adjustments following a promotion or a lateral transfer and shift differentials.

#7. Earnings From Side Jobs

Full-time workers may take on side projects or freelance work aside from their regular employment to earn additional income. Employees must use Form 1099-NEC to report earnings generated from freelance work.

What is Not Supplemental Pay?

Any compensation already included in a worker’s fixed pay does not qualify as supplemental pay. That’s because extra pay is an additional payment aside from employees’ regular earnings.

Here are examples of compensation that employers don’t categorize as supplemental income:

• Paid time off. Paid time off is an umbrella term that covers all the different types of compensated leaves or time off work granted to employees. It includes emergency leave, vacation leave, sick days, and mental health days. Employers include paid time off (PTO) in their employees’ basic pay. Whenever employees accumulate or use PTO, the additional and used hours are calculated and added to the workers’ net income.
• Stipends. Stipends are fixed sums disbursed to employees as financial assistance. Examples of stipends include child care or child support and moving expenses when personnel must relocate to fulfill their job.
• Vacation leave. Vacation leave is a more specific type of PTO, which employees typically use for leisure and recreation. Like PTO, vacation leave is already calculated as part of employees’ fixed income, which does not add to their regular bi-weekly, semi-monthly, or monthly pay.

Tax Implications for Supplemental Pay

The IRS tax implications for supplemental pay differ depending on how employers pay the said type of income. More specifically, supplemental income tax rates follow the conditions described below:

Separate Payment

If the supplemental income is paid separately, employers must impose a 22% flat rate on the additional wage, based on the IRS guidelines. The flat tax rate applies regardless of the employee’s regular withholding tax rate.

Combined Compensation

Combined compensation means employers pay supplemental income within the same check as their workers’ regular pay. In other words, the amount of additional pay is already integrated with the fixed income earned by the employee for a particular pay cycle.

In this situation, employers may withhold federal income tax rates based on the employee’s Form W-4. The combined compensation is taxed as a single payment.

Amount

The IRS imposes a 37% withholding tax rate for supplemental wages worth over $1,000,000. Note that the 37% rate is not fixed, as this may vary based on the highest income tax rate for the year when the employee received the supplemental income.

However, the supplemental pay does not exceed $1,000,000. In that case, employers can calculate the tax rates based on whether the additional payments are given separately or combined with their staff’s fixed income.

The Importance of Supplemental Pay

Supplemental pay benefits facilitate employers' need to properly recognize and reward their staff’s performance and achievements at work. Sometimes, a token of acknowledgment for their efforts is all it takes to motivate employees to continue their hard work.

At the same time, supplemental income in the form of salary increases and bonuses inspires employees to continue exceeding expectations and step outside of their comfort zones by taking on more challenging roles in the company.

Finally, employers must make the necessary adjustments if there are discrepancies in calculating employees’ salaries.

Whether they worked extra hours, received payment that does not coincide with their complete work hours, or are entitled to specific bonuses, receiving supplemental pay helps to address these necessary changes in their hard-earned money.

Final Thoughts

Granting supplemental pay to employees benefits them financially and helps improve their morale. It is essential that employers discuss the company's different types of additional wages and elaborate on how employees can qualify for them.

At the same time, companies should take note of the IRS guidelines on imposing supplemental income tax rates to ensure they do not withhold insufficient or excessive amounts from their employees’ well-deserved bonuses, overtime pay, severance pay, and other types of additional payments.