How to Determine Bonuses for Employees: Withholding and Tax Rules

To tax an employee bonus correctly under federal rules, treat it as supplemental wages: withhold federal income tax at a flat 22% if you pay the bonus separately from regular wages, or at 37% on any portion of an employee’s yearly supplemental wages that exceeds $1 million. On top of that withholding, the bonus is still subject to Social Security, Medicare, and federal unemployment taxes, and it gets reported as ordinary wages on the employee’s W-2 at year-end. Knowing how to tax employee bonuses comes down to picking the right withholding method, running payroll taxes correctly, and handling a few traps that catch employers off guard.

Federal Withholding: Flat Rate or Aggregate

The IRS classifies bonuses as supplemental wages, a category that also covers commissions, overtime, back pay, and severance. Supplemental wages have their own withholding rules, separate from the standard tables used for regular paychecks.¹ You have two ways to handle federal income tax withholding.

Flat Rate Method

When the bonus is paid as a separate check from regular wages, you can withhold a flat 22% for federal income tax. No bracket math, no reference to the employee’s W-4. Most payroll departments use this method because it’s clean and predictable.¹

If an employee’s total supplemental wages for the calendar year go above $1 million, everything over that threshold must be withheld at 37%, regardless of what the employee’s W-4 says.² Both rates were extended for 2026 and beyond after Congress passed P.L. 119-21.¹

Aggregate Method

If you combine the bonus with a regular paycheck instead of cutting a separate check, you must use the aggregate method. Add the bonus to the regular wages for the period, calculate withholding on the combined total using the standard tables as if it were a single payment, then subtract the withholding that would have applied to the regular wages alone. What’s left is the withholding on the bonus.²

Because the combined figure often lands in a higher bracket on the withholding tables, this method usually pulls more tax out of that paycheck than the flat 22% would. It’s the source of the familiar complaint that “my bonus was taxed at 40%.” It wasn’t. The withholding was temporarily inflated. The actual tax gets sorted out at filing.

Withholding Isn’t the Same as Tax Owed

The 22% flat rate is a withholding estimate, not a final tax rate. A bonus adds to the employee’s total income for the year and is taxed at their actual marginal rate. An employee whose marginal rate is 12% gets some of the 22% withholding back as a refund. An employee in the 32% bracket owes more at filing time. The withholding is a deposit, nothing more. Employees who ask why “so much” was taken out are usually asking the wrong question.

Payroll Taxes Still Apply

Federal income tax withholding is only one line item. Bonuses trigger the same payroll taxes as regular wages, and several of these hit the employer directly.

Social Security and Medicare

Both the employer and the employee owe 6.2% for Social Security on wages up to the 2026 taxable wage base of $184,500. Once an employee’s cumulative wages for the year cross that cap, no more Social Security tax is owed on additional payments, bonuses included. Medicare tax of 1.45% per side has no wage cap and applies to every dollar of bonus pay.³

For employees whose total wages exceed $200,000 in a calendar year, the employer must also withhold an additional 0.9% Medicare tax on the excess. The employer doesn’t match that portion. The $200,000 threshold applies regardless of the employee’s filing status, even though married couples filing jointly don’t actually owe the tax until combined wages exceed $250,000. That mismatch is reconciled on the employee’s return.⁴

Federal Unemployment Tax

Employers owe FUTA at a gross rate of 6.0% on the first $7,000 of wages paid to each employee during the year. Most employers qualify for a 5.4% credit against state unemployment contributions, dropping the effective rate to 0.6%. If an employee has already earned more than $7,000 in regular wages before receiving the bonus, the bonus adds no FUTA liability.⁵

State Withholding on Bonuses

Most states with an income tax also require withholding on supplemental wages. About half of those states let employers use a flat supplemental rate; the rest require the same withholding tables used for regular wages. Flat state rates range from under 2% to nearly 12%. A handful of states have no income tax, so no state withholding applies. Check your state revenue department for the specific rate and method, because getting this wrong creates a year-end mess for both you and the employee.

Overtime Recalculation for Non-Discretionary Bonuses

This is the trap that catches employers who otherwise handle the tax mechanics fine. Under the Fair Labor Standards Act, a non-discretionary bonus paid to a non-exempt (hourly) employee must be included in the employee’s regular rate of pay when calculating overtime. If you promised the bonus, tied it to performance targets, or created a pattern employees can rely on, it’s non-discretionary — and any overtime hours worked during the bonus period need to be recalculated.⁶

The math: divide the bonus by the total hours worked during the period it covers to get a bonus hourly rate. Multiply that rate by 0.5, then by the number of overtime hours in the period. The result is the extra overtime pay owed on the bonus.⁷ That extra payment is itself wages, subject to the same withholding and payroll taxes.

A truly discretionary bonus — one where the employer alone decides whether and how much to pay, with no prior promise or pattern creating an expectation — is excluded from the regular rate.⁸ The moment you announce a bonus program with defined criteria, it’s non-discretionary for overtime purposes, whatever the policy manual calls it.

Reporting the Bonus at Year-End

Employees: Form W-2

Bonuses are reported as part of total wages on the employee’s W-2. There’s no separate box for bonus income. It rolls into the wage total in Box 1, with the corresponding tax amounts in the withholding boxes. When the employee files, the bonus is simply part of their overall income for the year.

Independent Contractors: Form 1099-NEC

Bonuses paid to independent contractors follow different rules. If you pay a non-employee $600 or more during the year for services, report the total in Box 1 of Form 1099-NEC, including any bonus or incentive payment tied to the work. Performance awards to non-employee sales agents, for example, go in Box 1 of the 1099-NEC rather than on Form 1099-MISC.⁹ There is no employer withholding on a 1099 bonus; the contractor handles their own tax on it.

Deducting Bonuses as a Business Expense

Employee bonuses are generally deductible, but the IRS applies two conditions: the compensation must be reasonable for the services performed, and it must be an ordinary and necessary business expense.¹⁰ “Reasonable” is where employers get into trouble. A $200,000 bonus to a part-time administrative assistant will draw scrutiny. The IRS looks at the employee’s actual duties, comparable industry pay, and whether the whole compensation package makes sense for the role.

Timing for Accrual-Basis Employers

Cash-basis businesses deduct bonuses in the year paid. Accrual-basis businesses can deduct a bonus in the year the liability is established even if the payment falls after December 31, but only under the recurring item exception: the bonus must be paid within 8½ months after the close of the tax year.¹¹ For a calendar-year business, that means paying by September 15 of the following year. The total amount payable to the group must also be fixed by year-end, even if the individual allocations haven’t been finalized yet.¹²

The $1 Million Cap for Public Companies

Publicly traded corporations face an added limit. Under Section 162(m), the company cannot deduct more than $1 million per year in compensation for any covered employee. Covered employees include the CEO, CFO, the three other highest-paid officers, and anyone who was a covered employee in any prior year going back to 2017. For tax years beginning after December 31, 2026, the definition expands to include an additional five highest-compensated employees.¹³ Bonuses count toward this cap. A $900,000 salary plus a $400,000 bonus means only $1 million of the $1.3 million total can be deducted.

1
Internal Revenue Service. Publication 15 (2026), (Circular E), Employers Tax Guide
2
eCFR. 26 CFR 31.3402(g)-1 – Supplemental Wage Payments
3
Social Security Administration. Contribution and Benefit Base
4
Internal Revenue Service. Topic No. 560, Additional Medicare Tax
5
Internal Revenue Service. Topic No. 759, Form 940, Employers Annual Federal Unemployment Tax Return
6
U.S. Department of Labor. Fact Sheet 56C – Bonuses Under the Fair Labor Standards Act (FLSA)
7
eCFR. 5 CFR 551.514 – Nondiscretionary Bonuses
8
eCFR. 29 CFR 778.211 – Discretionary Bonuses
9
Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC
10
Office of the Law Revision Counsel. 26 U.S. Code 162 – Trade or Business Expenses
11
Office of the Law Revision Counsel. 26 U.S. Code 461 – General Rule for Taxable Year of Deduction
12
Internal Revenue Service. Revenue Ruling 2011-29 – General Rule for Taxable Year of Deduction
13
Federal Register. Certain Employee Remuneration in Excess of $1,000,000 Under Internal Revenue Code Section 162(m)