All employers have a duty to pay regular wages to their employees for their time. However, many also choose to offer supplemental pay. Offering a benefits package that includes supplementary forms of compensation can help you boost your employer brand so that you can attract and retain talent. In fact, many Americans claim that additional benefits are as important as salary – if not more so – when evaluating job opportunities.
But what is supplemental pay and how does it differ from other forms of employee benefits like healthcare and PTO?
In today’s post, we are going to explore supplemental pay from the perspective of an employer. We will explain what it is, what benefits qualify as supplemental pay, and how this form of compensation is taxed. We will also share a few tips and best practices to help you effectively manage supplemental pay in your business.
Table of Contents
What is supplemental pay?
Let’s start with the basics: what does supplemental pay mean?
Supplemental pay, also known as supplemental wages, is a form of monetary compensation that you can offer your employees in addition to their regular base salary. It can take a number of forms, including overtime pay, bonuses, accumulated sick leave, severance pay, retroactive pay increases, equity pay, pay for performance or any other additional compensation that you might offer an employee such as payouts for unused PTO/vacation. It does not include health insurance or any other form of non-monetary fringe benefit.
Although federal law requires you to pay overtime to all non-exempt employees who work over their contracted hours, all other forms of supplemental pay are optional. It is up to your business whether you offer any or all of these benefits. Nonetheless, offering some form of supplemental pay is common practice in most businesses. This is because it can be a great way to reward and incentivize employees and attract and retain top talent.
What qualifies as supplemental pay?
According to the IRS, supplemental pay includes:
- Overtime pay. Supplementary wages earned by a non-exempt employee who works any hours over their 40-hour workweek. According to the FLSA (Fair Labor Standards Act), you must pay employees 1.5 times their regular rate of pay for every additional hour worked.
- Accumulated sick leave. The FMLA doesn’t obligate employers to offer paid sick leave (although certain states do enforce it). If you do offer it, employees can choose to receive a payout for any unused sick leave in the form of supplemental wages.
- Severance pay. If you include a severance pay clause in an employee’s contract, then you must pay them severance pay when they leave the company. You can do this as a single payment or through multiple checks over a period of time.
- Retroactive pay increases. This can apply if an employee receives a raise at the end of a pay period that isn’t reflected in their paycheck until the next pay period. The payment makes up the difference between the amount they received in the last pay period and how much they were owed.
- Bonuses. Monetary amounts offered to employees as an incentive or a reward for high performance. Can include signing, referral, and retention bonuses in the form of cash or stock options.
- Equity pay. Compensation in the form of company stock options. Often used by new and growing companies that can’t be as competitive with their base pay or other taxable fringe benefits.
You can, of course, include additional types of supplemental wages in your compensation scheme. However, it’s important to understand what’s accepted as supplemental pay by the IRS, as this will impact how much tax you need to withhold.
For an overview of pay for performance models, check out our video on the subject:
Who should report supplemental wages?
As an employer, you are responsible for tracking and reporting supplemental pay. It’s therefore important that you maintain a record of how much supplemental pay you offer each employee.
This includes keeping a record of:
- The amount of supplemental wages an employee receives within the tax year.
- Whether you combine an employee’s supplemental wages with their regular wages or process them separately.
Although supplemental pay only forms a small part of an employee’s paycheck, it’s important to include processes in your payroll system to manage them effectively. That way, you will pay each employee the correct amount at the end of each pay period. This is fundamental for building an engaged and loyal workforce. An effective supplemental pay process also helps you comply with federal and state tax obligations, as we will see in more detail below.
How are supplemental wages taxed?
Supplemental pay is classed as taxable income. As a result, you are responsible for tracking and accurately reporting supplemental pay, as well as withholding the right amount of federal income tax from an employee’s supplemental wages. Moreover, supplemental pay is subject to FICA (Federal Insurance Contributions Act) payroll taxes so you are also responsible for withholding Social Security and Medicare contributions, as well as federal unemployment tax.
Because this form of compensation is not classed as an employee’s regular wage, the way you calculate federal income tax can be different. Withholding rules depend on how much money an employee receives in supplemental wages in a year, and how you process payments.
Essentially, in terms of federal income tax, you can process supplemental pay in one of two ways:
- Withhold a flat percentage on supplemental wages (percentage method)
- Combine supplemental and regular wages (aggregate method)
For example, if you pay a bonus to an employee in a separate bonus check, you must withhold federal income tax at a flat rate of 22%. However, if you include the same bonus in an employee’s regular paycheck and don’t specify that it is bonus pay, then you must calculate tax withholding based on the allowance marked by each employee on their W-4 form.
If you pay an employee more than $1 million in supplemental income in a year, then a different rate applies. In this case, all supplemental wages must be taxed at 37%.
Benefits like vacation pay and paid time off don’t qualify as supplemental income. These benefits are subject to the same withheld income tax as regular pay.
How to effectively manage supplemental pay
Supplemental wages can be difficult to understand, especially from a tax perspective. To help you out, we are going to finish today’s post by sharing a few tips and best practices to help you effectively manage supplemental pay.
Create a clear and transparent compensation policy
The best way to establish clear guidelines and procedures for managing supplemental pay is to create a clear and transparent compensation policy.
Your policy should include clear guidelines for salaries, and a detailed breakdown of each supplemental benefit that you offer. Make sure you explain how supplemental benefits are paid, how taxes are withheld, and whether these benefits are included in regular paychecks or paid separately.
Once you’ve created your compensation policy, make sure you share it with your entire workforce. This includes existing employees and new recruits. That way, your employees will understand exactly how your compensation scheme works and there will be no surprises or misunderstandings. Plus, being transparent in this way helps to build employee trust, vital for building a healthy and productive company culture.
Make sure you understand your tax obligations
It’s also vital that you understand all your supplemental pay tax and reporting obligations. The IRS website includes detailed guidelines for supplemental wages. This includes information on taxable benefits, tax rates, taxable thresholds, and tax report submission requirements.
If you’re still not clear on your tax obligations, then it’s a good idea to speak to a tax professional. They can help you understand all tax-reporting and submission obligations established by federal and state governments. That way, you can ensure compliance and avoid potential fines and penalties for late or inaccurate tax liabilities.
Use payroll software
Finally, make sure you have a comprehensive system in place for managing payroll. This will ensure that you calculate the right salaries and withhold the correct amounts for supplemental pay and all other payroll taxes.
The best way to manage all this is by using payroll software. With the right solution, you can automate all payroll calculations and deductions. You can also easily incorporate additional payroll systems such as on-demand pay with many solutions. Plus, a good system will provide you with detailed reports that you can submit to the IRS as and when required. You can also use these reports to access detailed insights about your company’s payroll and spending.
For example, at Factorial, we understand that payroll can be difficult to set up. Even more so if you offer supplemental pay. That’s why we want to provide you with a solution that centralizes all of your tasks on one, simple platform.
Features of Factorial’s payroll software include:
- Simplified benefits administration tools
- Customized payroll reports
- Easy integration with employee time-tracking data
- Automated tools for calculating payroll taxes, PTO, and sick days
- Variables and supplements
- Employee and supplement observations
- New hires and termination notifications
- Contract update notifications
- Payroll folders
- Custom notifications and automation features
- Payslip templates
What’s more, Factorial’s payroll software is a solid SaaS solution with a strong emphasis on payroll security. With Factorial, all database information is encrypted, helping you keep your sensitive data secure. The application uses a Single Sign-On system and vulnerability diagnostics are performed regularly.
All these features will help your supplemental pay systems run smoothly and securely so that you can stay compliant and build a happy and productive workforce.
