The definition of supplemental income is what you earn above and beyond your regular compensation. Most people understand the definition of regular income. It’s what you normally earn from your employer, and usually is just referred to as “income”. Supplemental income is a little more complicated and misunderstood. So what could be supplemental income?
WHAT IS SUPPLEMENTAL INCOME?
But what about supplemental income? Supplemental types of earnings are above and beyond what you typically earn, and are differentiated from regular earnings in that they are considered separate for tax purposes. Supplemental wages paid from an employer in addition to the person’s regular wages. Below is a list of some of the more common types of supplemental income:
- Overtime pay
- Severance pay
- Taxable fringe benefits — examples include unused vacation or sick days
- Retroactive pay
- Moving expense reimbursement
- Online side hustle
- Social Security benefits
This list of sources of supplemental income is by no means all-inclusive, but the idea is easy to understand. Because the two types of income are viewed as totally distinct from one another for tax purposes, it’s important that to understand what the difference means to your personal taxes as we enter into the new tax season.
HOW SUPPLEMENTAL INCOME IS PAID TO YOU
The first key difference to understand regarding regular and supplemental income is the time frame that the two are allowed to be paid out, according to the law. After you work and earn regular income, you are required to be compensated for this within a seven day window after the end of the pay period.
Conversely, supplemental income is not governed by the same time constraints. For example, a bonus that you earn for the last quarter the previous year may not be paid to you until February.
SOCIAL SECURITY INCOME
Then there is Supplemental Security Income, SSI, which is a government program that provides benefits (i.e., income payments) to disabled adults and children who meet low income thresholds. Social Security Income benefits also are payable to people 65 and older without disabilities who also meet the minimum thresholds.
WITHHOLDING SUPPLEMENTAL INCOME
A second primary factor that separates regular from supplemental income is the way that withholding is calculated. For regular income, the basis for withholding is usually your marital status and the number of allowances that you claim (think this form you complete when starting a new job).
Supplemental wages are a little trickier. There are three different acceptable options for withholding supplemental income taxes: the first is to add your entire wages together (regular and supplemental) and tax that entire amount. The second method allowed by the IRS is to tax the extra income at a flat 25% rate. Finally, a company can apply the relatively complex formula found here to tax your supplemental income and regular wages separately. Confirm with TurboTax or HRBlock.
One caveat: if you are lucky enough to earn over $1 million in extra income (hello, 1%!), that money must be taxed at the maximum allowed tax rate (currently 35%).
VACATION PAY AND TIPS
Your vacation pay and any tips earned are subject treated a little differently for tax purposes, depending on the situation.
Vacation pay is considered a supplemental form of income if the amount earned is greater than the regular income that you would have been paid during the time period in question.
If you are in a line of work where tips are involved, take note: tips are treated as supplemental income if you receive both wages and tips. In cases where your employer does not withhold tax from your regular earnings, the tips are added to the regular wages and that final amount is then taxed. However, if your employer does withhold tax on the regular hours that you work, tips are are subject to the 25% rate.
THE BONUS CONUNDRUM
Bonuses can be an exciting and fortunate extra boon to your pocket; however, some people experience a rude awakening when they see what a chunk that Uncle Sam has taken from that annual (or semi-annual, or quarterly) windfall.
If you end up with significantly less in bonus pay then expected, the culprit is most likely the withholding.
The reason is as follows:
Most employers choose to tax at the flat 25% rate if there is a separate check involved with your bonus. The reason is that it makes life easier on the accounting side for the company. In situations where your bonus money is lumped in with your regular paycheck, your tax liability will be higher since the amount being taxed is higher. To avoid a case of nasty bonus tax-shock, take a peek at this calculator, courtesy of TurboTax.
PAYING TAXES ON SUPPLEMENTAL INCOME
Also there are tax implications for different types of supplemental income. Check with your tax specialist or tax software to avoid concerns down the road.
Fortunately, (pun intended here at The Fortunate Investor), there are several benefits that are not taxed as supplemental income. The most common are usually moving expense reimbursements and other fringe benefits from your employer. These may include your company reimbursing you for business expenses. The expenses may include using your car for business or an on-site gym at the company location.
7 SUPPLEMENTAL INCOME JOBS TO HELP PAY THE BILLS
- Freelance. Become a freelance writer on Freelancer.
- Gig economy driver. Start as a Uber / Lyft driver.
- Online Surveys. Fill out online surveys such as Opinion Outpost or Pinecone.
- Vlog. Start a Vlog on Youtube to generate passive income and talk about something that interest you.
- Teach. Teach a class through a local college or Udemy online.
- Virtual Assistant. Become a virtual assistant / scheduler.
- Consulting. Start consulting on a topic you are an expert.
- Nanny/Babysit. This is straight forward you can be the neighborhood babysitter and start to make a lot of money in your free time.
- Share your expertise. Are you can expert? Find a hobby that you know about and can teach someone else. Offer instructions/lessons on guitar, working out, English, computer tech support, etc.
- Walk dogs. So there are apps that offer this service such as Wag. However, you can be the local dog walker and cut out the middleman for your neighbors and friends. Most pet owners are willing to spend as much on them as they would their own children.
- Website/Blogging. Have skills as a graphic designer, programmer, or web designer? Assisting with a web project is one of the easiest ways to make extra money online.
- Become a visiting professor. Trade schools, universities and local colleges offer classes in niche topics that you can use your expertise. You do not need to have a PHD but you should have some credibility to be a subject matter expert.
- Art. Have a crafty side? Consider opening a shop on Etsy or ArtFire. Put your crocheted blankets, homemade cards, and handcrafted jewelry on the market.
- House sit. Similar to dog walking or watching while people are on vacation you can watch their house while they are on vacation. This could be as simple as watering plants, getting the mail, taking out the recycling bin or other routine tasks that make it look like they are home.
- Rent A Room. If you have a house and it has some extra room you should consider renting out a room or multiple rooms. This is a real asset that you can convert into a great income generator.
TIPS FOR BUILDING SUPPLEMENTAL INCOME
Do you want to make more money or have your own business? This is a good time to start thinking of new investments, that could be investing in yourself such as education, a new business, the stock market, or other ways to increase your income.
First, you need to think about what your long term goal are and how you can achieve them. Start by thinking about your personal strengths and how you can add the most value. Ideally, this would be something that you are both good at and enjoy. Think of it as a job/hobby or a “jobby”. The point is that you enjoy doing it so much that it does not feel like work but fun.
It’s beginning to look a lot like bonus season as both Christmas and the end of the year quickly approach. While everyone enjoys the extra bonus money for the holidays, many people get very upset because they believe their bonuses are taxed at a higher tax rate. But what about how supplemental income impacts your taxes?
Similarly, many people avoid cashing out their vacation hours at the end of the year because they believe the vacation hours are taxed at a higher rate when they’re paid out, too. Luckily, these types of extra income aren’t actually taxed at a higher tax rate. They just seem like they are. It’s all part of the weird process known as the supplemental tax rate (sometimes called supplemental income tax).
How Your Supplemental Taxes Are Withheld
For any normal paycheck, your employer will withhold federal taxes based on Internal Revenue Service (IRS) guidelines. Similarly, when you earn a bonus or are paid out for vacation time, your employer has to withhold federal taxes. Unfortunately, the IRS treats supplemental wages, like bonuses, differently than regular wages. For most people, this different treatment makes it seems like you’re paying more taxes on your bonus than the rest of your income. However, a bit of knowledge will help you realize that isn’t the case. Also, use Turbo Tax to maximize your tax return.
What are Supplemental Wages?
Supplemental wages cover more than just bonuses and vacation time you sold back to your company. We’ve gone into greater depth on supplemental wages, but the simple definition is wage payments to an employee that aren’t regular wages. While that seems really broad, they give many examples of supplemental wages that include the following:
- overtime pay
- payments for accumulated sick leave
- severance pay
- back pay
- retroactive pay increases and
- payments for nondeductible moving expenses.
How Supplemental Wages Withholding Really Works
Withholding on supplemental wages, like bonuses, differs depending on how much money you make in supplemental wages. For the vast majority of people, it works as described below. However, if you earn more than $1,000,000 in supplemental wages, there are different rules that have to be followed. Thankfully, if you earn more than $1,000,000 in supplemental wages, you should be able to hire an accountant to explain it to you.
If your employer lumps all of your wages together, including regular and supplemental wages, then they must withhold taxes according to the usual IRS tables. This would make your annual income appear very high. For many people, this method would result in a higher withholding than the second method described below.
The second method is a much easier way to withhold taxes and is also much easier to understand. Your employer can simply withhold 25 percent of your supplement wages for federal taxes. Unfortunately, there are no other percentages your employer can withhold. Your employer’s hands are tied, even if you make a very low or very high income and would end up in a different tax bracket.
How Supplemental Tax Rate is Calculated
The IRS may require your employer to withhold 25% your supplemental wages, but you usually pay much less in federal tax withholding, doesn’t that mean you pay more in taxes on your bonus? Thankfully, it doesn’t. It is very unfortunate for most people that 25 percent is withheld from your bonus for federal taxes. The higher withholding may result in a smaller bonus check, but it reduces your supplemental tax rate – which is good unless you like paying more on taxes.
Just like with your regular federal tax withholding, supplemental wages withholding is just the IRS ensuring you pay your taxes. At the end of the year, you’ll file your tax return. Your return will determine how much tax you actually owe for the year. If you end up paying a lower effective tax rate, which is your total taxes owed divided by adjusted gross income, then you’ll get the difference back in your tax refund.
Of course, this is only true if you withheld the exact amount of income you should have on all of your other income. If you didn’t withhold enough money on your other income, the IRS will use some of the extra money withheld from your bonus to make up for the shortfall on your regular withholding.
Now You Can Educate Your Friends and Coworkers
Now you can set the record straight next time you hear someone complaining about the higher tax they pay on their bonuses. The 25 percent that is withheld is still a bummer. At least you now know and can explain that Uncle Sam won’t be keeping that money unless you really owe it. You’ll just have to wait until you file your taxes to get a refund check.
The Next Income Tax Bracket Isn’t as Bad as You Think
Once people learned I was an accountant early in my career, I often had a few acquaintances ask me questions in the weeks leading up to tax day. I have learned a great deal from the questions I have been asked. Federal income taxes in the United States are extremely complex. I’m not surprised so many people don’t understand how our tax system works. However, I was surprised by what I think is one of the largest misconceptions about our income tax system.
Note: All tax brackets in this article are for illustrative purposes only and are not the current tax brackets as issued by the IRS.
How People Think Tax Brackets Work
Just a few weeks ago I hired a plumber to make a repair at a property we were selling. We were talking about his busy schedule and how his boss was forcing him to work overtime. He liked the money, but was concerned that earning too much money due to the overtime would cause him to go up to the next tax bracket and greatly reduce his tax refund. In fact, he was so worried he said he’d quit his job once he hit his targeted income for the year to preserve his tax bracket status.
I spoke with the plumber for quite a while to try to understand why he was worried. I quickly discovered he thought going into the next tax bracket meant all of his income would be taxed at that new rate. For instance, the plumber thought if he earned $39,999 and was in the 10% tax bracket, he’d only owe $3,999.99 but if he earned $40,000 and was put into the 15% tax bracket he’d owe $6,000. Fortunately, that’s not how the United States federal income tax bracket system works.
How Tax Brackets Really Work
The federal income tax system works based on marginal income tax rates. Essentially, a marginal income tax system works by taxing you on each additional dollar of income you earn, not your entire income. As you move up to a higher tax bracket, only the additional income you earn in that higher bracket will be taxed at the higher rate. This is much easier explained using a quick example.
For this example, the tax brackets are as follows:
$0 to $9,999 – 0%
$10,000 – $19,999 – 10%
$20,000 – $39,999 – 15%
$40,000 – $74,999 – 25%
$75,000 and up – 30%
Let’s pretend Bob will make a $30,000 salary this year. If you’re like the plumber that came to my house a few weeks ago, you’d think Bob would owe 15% on his total salary of $30,000 for a total tax bill of $4,500. Thankfully, that isn’t how it works.
Based on the above tax brackets, he would pay $0 on his first $9,999 of income, he would pay 10%, or $1,000, on his next $10,000 of income, and 15%, or $1,500, on the last $10,000 of income. His total tax owed would be $2,500. If Bob earned a bonus and made over $39,999, only the income above $39,999 would be taxed at 25%.
You Are Taxed More as You Earn More
The marginal tax system works in an interesting way. The more money you earn, the more taxes you pay on that money. This makes sense to help people not earning as much to keep more of the money they earn. However, it also means people have less incentive to earn each additional dollar.
When you’re earning income in the 15% tax bracket, you get to keep 85% of the money. However, if you’re in the 25% tax bracket, you only get to keep 75%. As tax brackets continue increasing, you have to evaluate if it is worth your effort to make more money while keeping less. Personally, I always say earning more income is a good. Yes, I keep less, but I may not have to put in as much effort to earn the additional income.
Other Tax Considerations
Taxes are way more complex than a simple marginal tax bracket. There are many, many deductions, credits and other tax items that change based on how much income you earn. As your earnings increase, you generally qualify for less tax deductions and credits. In fact, some deductions and credits completely go away if you make too much money. For that reason, it is important to talk to a tax professional to make a customized plan for your specific tax situation. At least your tax person won’t have to explain how the marginal tax system works.
Unfortunately, if you only visit a tax professional at tax filing time, it may be too late. Many tax planning strategies only work if you have time to make adjustments. If the tax year is over, there are very few adjustments you can make. At least your tax person won’t have to explain how the marginal tax system works.