How to Pay Employee Bonuses: A Guide for Small Business Owners

Pay an employee bonus through your payroll process and treat it as supplemental wages for federal withholding purposes. Before you process payroll, determine what kind of bonus you’re paying, how federal income tax withholding applies, and whether the bonus may affect overtime pay.

You’ll also account for Social Security and Medicare (FICA) taxes and any applicable state or local withholding.

With SurePayroll® By Paychex, you can include bonuses as a compensation type when you pay your employees.

How employee bonuses work through payroll

A bonus is more than an extra payment to an employee. How you structure bonus payments can affect withholding, overtime, and other payroll considerations.

Start with these questions:

• Is the bonus discretionary or nondiscretionary? This distinction can affect overtime calculations for nonexempt employees.

• Will you pay the bonus with regular wages or identify it separately? That affects the federal income tax withholding methods available.

• What other payroll taxes and withholding apply? Account for Social Security and Medicare taxes, plus applicable state and local requirements.

Employee bonuses can take different forms, including year-end bonuses, holiday bonuses, retention bonuses, referral bonuses, and spot bonuses. Whatever you call the payment, determine how the bonus is structured before you process it through payroll.

Determine whether the bonus is discretionary or nondiscretionary

Before you run the bonus through payroll, determine whether it’s discretionary or nondiscretionary.

A discretionary bonus is generally one you decide whether to pay and how much to give, without a prior promise or agreement that causes employees to expect the payment. A nondiscretionary bonus is generally promised in advance or tied to defined criteria such as productivity, attendance, or performance.

That distinction matters for nonexempt employees. A nondiscretionary bonus generally must be included in the regular-rate calculation used to determine overtime pay for a nonexempt employee.

‍Calculate federal income tax withholding on the bonus

Bonuses are supplemental wages for federal income tax withholding. The way you pay the bonus determines how you calculate that withholding.

Pay the bonus as part of regular wages without listing the bonus amount separately, and you calculate federal income tax withholding on the full payment as regular wages.

Pay the bonus separately, or list the bonus amount separately from regular wages, and supplemental wage withholding rules apply. Start with the employee’s regular wages: if you withheld federal income tax from them during the current or immediately preceding calendar year, you can generally use one of two IRS methods to calculate withholding on the bonus.

• Percentage method: Apply the IRS flat supplemental withholding rate to the bonus.

• Aggregate method: Combine the bonus with regular wages to calculate withholding, then subtract the federal income tax withheld from the regular wages.

Percentage method

With the percentage method, you withhold federal income tax from the bonus at the flat rate of 22% for supplemental wages.

The 22% rate determines how much federal income tax you withhold from the bonus. It does not determine the employee’s final income tax liability.

For example, if you pay an employee a $1,000 bonus separately from regular wages and use the 22% percentage method, you withhold $220 in federal income tax from the bonus. Other payroll taxes and applicable state or local withholding may also apply.

Aggregate method

With the aggregate method, you combine the bonus with regular wages to calculate federal income tax withholding. Subtract the federal income tax withheld from the regular wages, then withhold the difference from the bonus.

The amount withheld can differ from the percentage method because the aggregate method uses the withholding calculation that applies to the combined wages. It does not mean the bonus itself is taxed at a different income tax rate.

Supplemental wages over $1 million

Once an employee’s supplemental wages exceed $1 million during the calendar year, a different federal withholding rule applies. You must withhold 37% on the amount above $1 million.

Account for Social Security and Medicare taxes on the bonus

Federal income tax withholding is only part of the calculation. You also account for Social Security and Medicare taxes when you pay an employee bonus.

These taxes fall under the Federal Insurance Contributions Act (FICA). You withhold the employee’s share from the bonus and account for the employer share as part of your payroll tax obligation.

Social Security tax applies up to the annual wage base. Medicare tax doesn’t have the same wage cap, and Additional Medicare Tax withholding may apply once an employee’s wages exceed the federal withholding threshold.

That means the amount you withhold from a bonus can include:

• federal income tax withholding

• Social Security tax

• Medicare tax

• Additional Medicare Tax withholding, if applicable

• state and local withholding, where required

Check state and local withholding requirements

Federal withholding rules are only part of the tax implications of paying an employee bonus. You also need to account for any state and local withholding that applies to the employee’s bonus.

States set their own withholding rules, including rules for supplemental wages. Local income taxes may also apply depending on where the employee works or lives.

Check the requirements that apply to the employee before you run the bonus. If you have employees in more than one state, evaluate each employee based on the applicable state and local rules rather than applying one approach across your team.

Pay and report the bonus through payroll

Once you’ve calculated the bonus and applicable withholding, process the bonus payout through the employee’s payroll.

Deposit the related payroll taxes according to your applicable federal, state, and local deposit schedules. Report the bonus and related taxes with your other wages and payroll taxes on the applicable employment tax returns.

Make the bonus part of your next pay run

Once you’ve set the bonus amount and pay date, you’re ready to move from planning to payroll.

SurePayroll supports bonus pay alongside the other compensation you already pay your team.