Incentives are the perfect way to recognize employees for exceptional performance, goal achievement and for when your team exceeds all expectations. These bonuses are also ideal in creating added motivation for employees to meet certain targets and performance objectives. When you are participating in incentive programs however, it’s important to know that tax laws often come into effect with this type of pay.
Workplace incentive pay and rewards are generally taxed like other categories of income, but they are measured on a different scale and there can be some exceptions to remain aware about too. This article will introduce you to the incentive tax system and help you understand important concepts such as the types of incentives that work best for your team and meeting the requirements for tax on these incentives.
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It’s important to understand the difference between how incentive pay/bonuses are taxed compared to regular income tax for employees. The latter depends on which income bracket an employee falls into - for example, if someone earns up to about $10 000 per year, the tax is generally 10% and this percentage will increase as the employee’s salary does.
One of the most significant differences between these two then, is that the incentive pay tax rate (sometimes referred to as the “federal withholding rate”) is much higher - sitting at around 22% - than the regular income tax rate.
Along with this, the IRS considers incentives and bonuses to be “supplemental wages” meaning that they are not part of an employee’s regular income. Not only would bonuses and paid incentives (including signing bonuses and severance pay) fit into this supplemental wage category but the following would too: commission, prizes/awards, over-time pay and reported tips.
Similarly to how a business deducts tax from a regular salary, a deduction is made from incentive pay too. Known as “tax withholding”, this is sent to the IRS by the company on the employee’s behalf.
There are two ways to calculate tax withholding: the percentage method and the aggregate method. We’ll explain these briefly below.
The Percentage Method is the simplest way to calculate incentive pay tax and it also tends to leave more money in the employee’s pocket.
For bonuses up to $1 million, this method calculates the tax based on a federal flat rate of 22%. If you make an admirable bonus of over $1 million (and congratulations on this), the rate will unfortunately climb to 37%.
It’s also important to note that FICA taxes (referring to the Federal Insurance Contributions Act) are also deducted on top of this flat rate. These are compulsory deductions for Social Security and Medicare taxes.
FICA taxes come to 7.65%, and this number is the result of the 6.2% Social Security rate added with the 1.45% Medicare rate. Employees that earn a higher pay also have to pay additional Medicare taxes.
To illustrate The Percentage Method, consider this example:
For a $100 bonus, federal tax is calculated as: $100 x 0.22 = $22.
This means that an employee will pay $22 in federal taxes for the $100 bonus and will be left with $78.
You will then need to deduct the 7.65% in FICA taxes using a similar calculation.
This method can be more complicated than The Percentage Method and it can also mean a smaller bonus for the employee upfront.
Use The Aggregate Method to calculate incentive pay tax if bonuses are paid with regular monthly wages, as they are taxed according to the employee’s tax bracket. Although this means that the monthly tax withholding is higher, the employee will be able to request a tax refund when filing season arrives.
To illustrate The Aggregate Method, consider this example:
An employee receives $1000 monthly salary and is also awarded a monthly bonus of $100. Their gross salary, before tax, is now $1100.
The employer will use this total amount to calculate the incentive pay tax and it will resemble the same amount that is withheld from the employee’s regular income tax (e.g. if 10% is normally withheld for income tax, then 10% will be withheld for the bonus too)
When using The Aggregate Method, tax is calculated on an assumed annual salary that the employee isn’t necessarily receiving.
Even if they only received a bonus for one month in the whole year, their tax bracket can change.
The remedy for this correction is through the employee’s tax return and just means added admin work for the company and the employee.
Related: How To Calculate Incentive Pay
In a few cases, there can be exceptions to these described tax rules in the form of bonuses qualifying as employee achievement awards rather than incentive pay.
The following conditions can allow for a bonus to be considered an employee achievement reward or another kind of untaxed incentive:
Alongside the additional Social Security and Medicare taxes, applicable state or local taxes need to be taken into account when calculating the tax on incentives and bonuses.
For example, New York tax legislation requires business owners to withhold 11.7% from supplemental pay. You can get more information on state requirements here.
Bear in mind that bonuses and other incentive wages are also subject to federal unemployment (FUTA) and state unemployment (SUTA) tax.
Rewarding your employees can be a convenient, simple and highly effective process - especially when you don’t have to worry about the tax!
PerkUp has all the information you need about handling tax with our free downloadable guides. These guides cover tax compliance in the USA and Canada, and will help educate you further about tax allocations, exclusions and the timeline and context for what information you need to report.
Without an extra thought to put towards sorting out incentive pay tax, you can place your energy on creating the best rewards experience for your employees.
Choose from thousands of reward options on PerkUp, send your employees personalized messages, and schedule rewards to keep your employees motivated!
Tax, especially incentive pay tax, is unavoidable due to their categorization as “supplemental wages” and the IRS’s consideration of bonuses and incentives as taxable.
Understanding the two tax calculation methods will help you decide how to complete the process in the best way possible for your company and employees, and comes down to your preference in paying out employee bonuses.
If you decide to pay these bonuses independently from regular salaries, it will be easier but may also mean extra admin work for the payroll office.
If your company prefers to pay them together with the employee’s salary, it may be more complicated to work out and would mean less money that’s readily available for your employee. However, it can also have better overall long-term benefits.
Take the time to think about what works best for your company and always make informed and well-educated decisions!