Overtime and Taxes

Many of us put in extra hours at work to help make ends meet, buy Christmas presents and just have a few more dollars. I have always heard that the government takes most of the overtime pay so I decided to do some calculations.

If you do a lot of overtime though, you need to be conscious of how your additional earnings will affect your tax liability at the end of the year. If you know your overtime rate, you can calculate how much more of your money is withheld over the course of a year and whether you need to think strategically about the hours you're putting in.

The first thing to consider is that you are taxed annually, not on each check. That is why some people can pay quarterly taxes and so forth. The taxes of each paycheck are based on your annual earnings assuming that pay were the same throughout the year.  So it is true that you may move into a higher bracket for a specified time period while not necessarily moving into the higher bracket for the year.  

The employer can elect how the tax is withheld from your pay. The simple overview is they can simply add it to the regular hours and withhold taxes form that amount or they can elect to use one of the supplemental methods. The simple example is at the end of the post.

Supplemental Method

According to the IRS’ Circular E- Employers Tax Guide, supplemental wages are wage payments to an employee paid during the payroll period that are not regular wages. They include, but are not limited to, bonuses, commissions, overtime pay, and payments for accumulated sick leave, severance pay, awards, prizes, back pay, retroactive pay increases, and payments for nondeductible moving expenses. Other payments subject to the supplemental wage rules include taxable fringe benefits and expense allowances paid under a non-accountable plan. How you withhold on supplemental wages depends on whether the supplemental payment is identified as a separate payment from regular wages. See Reg- 2. Section 31.3402(g)-1 for additional guidance for employee’s regular wages paid after January 1, 2007. Also see Revenue Ruling 2008-29, 2008-24 I.R.B. 1149, available at www.irs.gov/irb/2008-24_IRB/ar08.html.

Since these are taxes there is no simple answer. The fact is that the employer has a choice on how to withhold the tax from your paycheck. Here are some examples.

Example 1 is to simply withhold the tax based on the total amount (regular hours + overtime).

Example 2- You pay a base salary on the 1st of each month. She is single and claims one allowance. Her May 1 pay is $2,000. Using the wage period covered by the wage payment bracket tables, you withhold $195. On May 14 she receives a bonus of $1,000. Electing to use supplemental wage withholding method 1-b, you;

1. Add the bonus amount to the amount of wages from the last wage payment made during the most recent base salary pay date (May 1) ($2,000 + $1,000 = $3,000).

2. Determine the amount of withholding on the combined $3,000 amount to be $345 using the wage bracket tables.

3. Subtract the amount withheld from wages on the most recent base salary pay date (May 1) from the pay an employee for a period of less than one week, and combined withholding amount ($345 – $195 = $150

4. Withhold $150 from the bonus payment.

Example 3-The facts are the same as in Example 2, except you elect to use the flat rate method of withholding on the bonus. You withhold 25% of $1,000, or $250, from wages subject to withholding, the employee’s bonus payment.

Example 4-The facts are the same as in Example 2, except you elect to pay a second bonus of $2,000 on May 28. Using supplemental wage withholding method 1-b, you:

1. Add the first and second bonus amounts to the amount of wages from the most recent base salary pay date (May 1) ($2,000 + $1,000 + $2,000 = $5,000).

2. Determine the amount of withholding on the combined $5,000 amount to be $811 using the wage bracket tables.

3. Subtract the amounts withheld from wages on the most recent base salary pay date (May 1) and the amounts withheld from the first bonus payment from the combined withholding ($811 – $195 – $150 = $466).

4. Withhold $466 from the second bonus payment.

The “Simple” Example

As you can see the amount of tax on overtime may vary depending on the method used.  Even if your employer decides to simply add the amounts together for taxation, there is a Wage Bracket Method and a more complicated Percentage Method.  For simplicity (a bit late maybe) we will use the Wage Bracket Method for our own example.

If you normally earn $1550.00 (gross taxable income) biweekly then your withholding would be $183.00 (with one dependant claimed). If you then earn an extra $300.00 in overtime the tax is $258.00 (1550.00 + 300.00 = 1850.00). This adds $75.00 to your tax for the paycheck with the additional hours. That is 11.8% on the regular wage while paying 25% for the additional 300.00 if you break it up (183/1550=.118) and (75/300=.25). More accurately the total tax is 13.9% (258/1850=.139).  The overtime will put you in a higher tax bracket for a given pay period.

If you earned this $1550.00 throughout the year you would earn approximately $37,200.00 annually. And if you earned $1200.00 in overtime for the year the total is now $38,400.00. The tax (according to the IRS Tax Calculator) would be $3179 or 8.5% for the $37,200 while the tax on the $38,400 is estimated to be $3359 or 8.7%. The difference is $180.00. Using the break up method you pay 15% on the overtime pay (180/12000=.15) which is still 10% less than the 25% of a single pay period overtime tax.

All of this to say you will pay more tax on more income. The statement that you get taxed more for overtime is not necessarily accurate in that there is not a single rule to tax overtime using a different method. The choice for the amount withheld per pay period is up to your employer.