Supplemental income refers to extra earnings received on top of your regular paycheck. People earn this type of income in various ways, like getting bonuses, commissions, rental income, or even proceeds from investments. The IRS handles supplemental income differently because it’s often irregular or unpredictable, which is why they require specific protocols to avoid underpayment. Here, we’ll cover the different types of supplemental pay and how the earnings are taxed.
What is considered supplemental income?
You can better understand how different types of supplemental income are taxed by considering their source and your involvement in generating them. If you are an employee, your supplemental income will differ from a freelancer’s. You might earn money from renting out property, or through owning a part of a partnership or S Corporation. Each of these sources of income has its own set of rules for how you need to report it on your taxes. To clarify this, let’s look at some real-life examples of different types of supplemental income.
1. Supplemental income as an employee
When considering supplemental income, you probably think of earning additional income while being an employee. If you’re a traditional employee, there are various ways in which you can receive supplemental income apart from your regular payroll wages. These wage supplements may look like this:
- Bonuses – An employer may offer performance-based bonuses, including holiday bonuses.
- Commissions – Commission income is in return for services performed and typically a percentage of sales made or a fixed amount per sale.
- Overtime pay – Pay for working beyond your normal business hours may be considered supplemental wages. However, employers have the option to treat overtime pay and tips as regular wages instead of supplemental wages.
- Taxable fringe benefits – Employer-provided non-cash benefits, such as health insurance, personal use of company-owned assets, gym memberships, or even expense reimbursements (such as non-deductible moving expenses) may be considered a supplement to your regular wages.
- Retroactive pay increases or back pay – In most cases, if you receive additional income for unpaid or underpaid work, the IRS categorizes this as a supplement to your wages.
- Reported tips – If you work in a service industry or profession, tips you earn are additional income, not part of your regular wages.
The supplemental wages you receive as an employee are usually included in the W-2 you receive from your employer. You need to report this information when filing your tax return. IRS Publication 15 instructions provides several examples of income your employer may categorize as supplemental wages, such as severance pay, awards, prizes, payments for unused PTO, and accumulated sick leave.
2. Supplemental income reported on Schedule E
Schedule E is designed to report income or loss from certain passive activities or investments. The types of supplemental income reported on Schedule E typically involve passive participation or ownership interests in various entities or assets. Here are the types of income reported on Schedule E:
- Rental real estate and royalty income – Income earned from renting out your property (such as Airbnb or VRBO rentals) or allowing others to use your intellectual property (such as patents, copyrights, or trademarks) in exchange for payment is considered supplemental wages.
- Partnerships and S Corporations – If you share in the profits of a business with two or more owners, this income is an addition to income that gets reported on Schedule E.
- Estates and trusts – If you are the beneficiary of a trust that invests in bonds, stocks, or savings accounts, any interest earned on those investments are considered supplemental income from the trust.
- Real Estate Mortgage Investment Conduits (REMICs) – Investors in REMICs may receive income from the interest and principal payments made on the mortgages. Residual interest payments should be reported on your Schedule E as supplemental income.
3. Supplemental income for self-employed
If you have a side job, any income you earn can be considered supplementary to your regular income. For tax purposes, you are regarded as self-employed and must report the income earned from selling goods or services on Schedule C as self-employment income. While Schedule C income is subject to self-employment tax, an advantage is you can deduct business-related expenses.
How is supplemental income taxed?
Now that you understand the various ways to generate supplemental income, you may wonder how it is taxed. The answer is it differs based on the amount of supplemental income and how it was earned. Let’s take a closer look at each category of income.
1. How employee supplemental income is taxed
Just like regular wages, whenever you receive additional income like bonuses, commissions, or overtime pay, it is subject to federal income tax, Social Security tax, and Medicare tax. The amount of tax withheld depends on how your employer pays out your wages.
When your employer pays you, they can either choose to combine or separate your supplemental wages from your regular wages. If your supplemental income is included with your regular wages, you will likely have taxes withheld at the same rate as your regular wages.
If your supplemental income is paid out separately, then your employer may opt to withhold a flat rate of 22% (or up to 37% for amounts over $1,000,000), regardless of your tax bracket or W-4. This is different from regular wages, which are subject to withholding based on your Form W-4 information. We discuss supplemental tax rates further in the following section
Employers typically report supplemental income on Form W-2 at the end of the year. The supplemental income is included in box 1 (wages, tips, other compensation) of your Form W-2, along with your regular wages.
2. How Schedule E supplemental income is taxed
Rental income
If you’re renting out a property, this income is subject to federal and state taxes. Schedule E allows you to deduct rental expenses, such as mortgage interest, property taxes, insurance, maintenance costs, utilities, and depreciation. This income is generally considered a passive-activity, so it is not subject to self-employment tax. However, if you offer significant services primarily for your tenant’s convenience, you may need to report this income on Schedule C and pay self-employment tax.
Royalty income
Royalty income gets taxed as ordinary income at the federal and state levels. The payer typically reports income from royalties using Form 1099-MISC or Form 1099-NEC. These forms provide details about the royalty income received during the tax year, including the total amount paid and any taxes withheld. Although, the payer does not typically withhold taxes for royalty income. Instead, you may need to make estimated tax payments throughout the year. This income may also be subject to self-employment tax if you license or sell intellectual property.
Partnerships and S Corporations
Income from S Corporations or Partnerships is passed through to shareholders or partners and reported on their personal tax returns using Schedule K-1. This income is subject to federal income tax and state taxes. Typically, the entity does not withhold taxes, so as a shareholder or partner, you may need to make quarterly estimated payments to account for your tax liability.
Estates and trusts
Income from estates and trusts is subject to federal and state tax. As the beneficiary, you receive income details on Schedule K-1 reporting your share of income, deductions, and credits. The estate or trust does not typically withhold taxes, so beneficiaries may need to make estimated tax payments.
What is the supplemental tax rate?
Your employer will typically withhold a flat 22% for federal supplemental tax on amounts up to $1 million. Amounts exceeding $1 million may be subject to a 37% tax withholding.
However, it’s important to note that not all types of supplemental income are taxed at the same rate. For example, self-employment income, rental income, royalty income, and income from partnerships or S corporations are taxed at regular income tax rates, which vary based on your total taxable income and filing status. Therefore, the tax rate applied to supplemental income depends on the specific type of income and individual tax circumstances.
What type of income is not subject to taxes?
As you go through your tax forms, you might come across other sources of income that you received in addition to your primary income during the year. Although it’s always a good idea to assume that most earnings are taxable, some are exempt from taxation.
- Gifts and inheritances: Money or property received as a gift or inheritance is generally not taxable income for the recipient.
- Scholarships and grants: Funds received as scholarships or grants for educational purposes are often exempt from income tax if they are used for qualified expenses such as tuition, fees, and books.
- Child support: Payments received as child support are not considered taxable income for the recipient parent.
More examples of fully or partially non-taxable income include life insurance proceeds, disability income, welfare payments, and social security income.
Supplemental Income FAQs
In this FAQ section, we answer common questions about supplemental income, including tax rates, example scenarios, and how it differs from other types of income.
What is the difference between supplemental wages and regular wages?
Supplemental wages are additional payments made to employees apart from their regular wages. These payments may include commissions, overtime pay, fringe benefits, or reported tips. Unlike your regular salary, which is usually paid on a fixed schedule, supplemental wages are typically irregular or occasional. As a result, they are subject to different tax withholding rates for federal income tax purposes.
What is an example of supplemental pay?
As an employee, if you meet or exceed your performance targets, you may receive a bonus, which is an example of supplemental pay. Other examples of supplemental pay include unused PTO pay out, back pay, severance pay, prizes, and awards.
Supplemental income can also be rental income received from owning and renting property. This kind of income is considered supplemental because it is in addition to your regular salary or wages. It needs to be reported on Schedule E along with any expenses associated with owning the rental property.
How much is supplemental income taxed?
Supplemental income is generally taxed at ordinary income tax rates, which vary depending on your total taxable income and filing status. However, certain types of supplemental income, such as bonuses or commissions, may be subject to higher withholding rates for federal income tax, such as the flat rate of 22% for certain supplemental wages.
Why is supplemental income taxed higher than other types of income?
Supplemental pay is typically subject to Social Security and Medicare taxes. However, the way your employer pays you (whether combined with your paycheck or given out separately), can affect whether you have already paid those taxes upfront. To prevent underpayment at the end of the year, the IRS requires a higher tax withholding rate.
