What Is Supplemental Income – and How is it Taxed?

Supplementing your primary income with extra cash can help you achieve your financial goals – whether you’re saving to buy a house or for retirement, aiming to reduce debt, or looking to build a fund for emergencies. Ways to earn supplemental income include:

• Commissions, overtime pay, or bonuses from your employer in addition to your regular pay.
• Side gigs such as driving, teaching, consulting, or odd jobs.

Wherever you earn your supplemental income, be aware of the tax implications, especially if you want to avoid surprises when you file your income taxes. The IRS taxes different types of income in different ways.

Employees may receive a variety of supplemental income payments from their employers in addition to their regular paycheck. They include:·     

• Overtime pay.
• Tips.
• Bonuses or awards.
• Payments for accumulated or unused time off.
• Severance pay.
• Back pay and retroactive pay increases. 

These extra payments generally are regarded and taxed as “supplemental wages,” according to the IRS. Depending in part on how your employer pays out the money, taxes may be withheld differently from the rest of your paycheck.¹

• Combined payment. If you receive the supplemental income together with your regular wages in a single combined payment, your employer may withhold federal income tax in the same way as for your regular pay, taking into account your existing tax allowances.  
• Separate payment. If you receive the supplemental income as a separate payment, IRS guidelines give employers the option to withhold income tax on the payment at a flat rate of 22%, regardless of your normal tax withholding rate. In some cases, this may mean that a bigger bite gets taken out of your supplemental income payment than comes out of your regular pay.
  
• Over $1 million. If you’re fortunate enough to receive more than $1 million in supplemental wages, any amount over $1 million is taxed at a higher rate, which is 37% in 2020.   

Your employer also will deduct Social Security and Medicare taxes, as well as any state income taxes, regardless of how much federal income tax is withheld. 

The way taxes are withheld when you receive the payment doesn’t affect the total amount of income tax you owe for the entire year. If 22% was withheld from your supplemental wages, you might get a refund at the end of the year. However, experts say that if you received enough supplemental income to put you into a higher income tax bracket, you might owe the IRS money at the end of the year. To better understand tax brackets, read “How to File Taxes.”

There are more ways than ever to make money outside your regular job, in part because of the rise of gig economy apps, like ride-hailing and task-sharing, and their online platforms. Side gigs offer the flexibility to generate supplemental income whenever it suits your schedule. Here are some typical side gigs:

• Drive for a ride-share service.
• Rent out part or all of your home during the year.  
• Teach something you’re good at. Your professional experience could qualify you to teach at a local college, or your skiing skills could get you a gig guiding newbies down the slopes.
• Start a consulting service, using your business or technical skills to help others.
• Sell crafts or art online.
• Offer your services on a platform that matches you with people who need odd jobs, such as home repairs, moving, or shopping. 

With gig work, you may be classified as self-employed for tax purposes. If you receive at least $600 in supplemental income from, for example, a ride-sharing platform, you may receive tax forms such as a 1099-K or 1099-MISC documenting how much they paid you as a self-employed contractor. Even if you don’t receive these forms, you’re still responsible for tracking supplemental income and paying any appropriate taxes. 

Being classified as self-employed can make filing your taxes more complicated, but it also has advantages. You may need to report your self-employed income on a separate IRS form – Schedule C or Schedule C-EZ – at the end of the year. And you may be required to make estimated tax payments throughout the year if you expect to owe $1,000 or more in federal income tax due to your gig work.

The good news is that you may be able to deduct various expenses related to your side gig. These expenses reduce your taxable income so you pay less income tax. Typical expenses may include:

• Business mileage on your car.
• Business use of your home.
• Tools and equipment necessary for your side gig.
• Tuition for business-related education.
• Dues and subscriptions paid to business-related organizations.

There are many ways to earn supplemental income that gets you closer to your financial goals. Whether you earn extra money within your job or from side gigs, be aware of the tax implications and consider consulting a tax professional if you have concerns. Supplemental income can affect how much tax you owe at the end of the year – and if you’re classified as self-employed, you may have to make estimated tax payments during the year too.