Special Withholding Situations: Bonuses, Stock Awards, and Tips

Why these payments are treated differently

Employees receive different withholding treatment for irregular pay because withholding must approximate the right tax liability without knowing a taxpayer’s full-year income. Bonuses, stock awards, and tips are “supplemental wages” or irregular receipts for payroll purposes, and the IRS prescribes specific methods employers may use to withhold income tax and payroll tax to reduce surprises at filing time (IRS: Supplemental Wage Payments, https://www.irs.gov/newsroom/supplemental-wage-payments).

In my 15 years advising clients on payroll and personal tax planning, the most common problems I see are (1) people not realizing withholding on supplemental pay is frequently flat and higher than take‑home expectations, and (2) stock awards driving large paper income in one year that triggers unexpected tax bills. The guidance below explains the common rules, how employers typically apply them, and practical steps you can take.

Bonuses: methods employers use and what it means for you

Employers must withhold income tax, Social Security, and Medicare on bonuses. For federal income tax, employers usually choose one of two IRS‑approved approaches:

• Flat supplemental rate method. For standard supplemental wages, employers generally withhold a flat federal income tax rate of 22% (for most supplemental wages) when the bonus is paid separately from regular wages. For very large supplemental wages (exceeding $1,000,000 in a calendar year paid to a single employee), the withholding rate rises to the highest statutory rate (currently 37%). Employers may also need to withhold state income tax at rates set by the state. (IRS: Supplemental Wage Payments, https://www.irs.gov/newsroom/supplemental-wage-payments)

• Aggregate method. If the bonus is paid with regular wages and not identified separately, the employer can aggregate the bonus with that pay and withhold as though the total were a single payroll payment. This can yield a higher or lower withholding amount depending on the employee’s payroll tax table bracket.

Practical example: a $10,000 year‑end bonus withheld at the 22% flat rate results in $2,200 withheld for federal income tax. Employers still withhold Social Security and Medicare on the bonus (7.65% combined for employees on earnings subject to those taxes), which further reduces take‑home pay.

Employee steps to manage bonuses

• Ask payroll how they will withhold (flat 22% vs. aggregate). If the flat rate will leave you underwithheld for the year, increase withholding on future paychecks using Form W‑4 or make an estimated tax payment.
• If you expect to owe more tax because of a large bonus, you can ask HR to withhold additional federal income tax from the bonus check.
• Read more about adjusting your payroll withholding on Form W‑4 in our guide: Understanding Paycheck Withholdings: W‑4 Basics.

Stock awards: RSUs, stock options, and withholding on vesting or exercises

Stock compensation is diverse. The two most common types are restricted stock units (RSUs) and stock options (nonqualified stock options — NSOs — or incentive stock options — ISOs). Each has different tax and withholding rules:

• RSUs (Restricted Stock Units): RSUs are taxable when they vest (the employee receives shares without restrictions). The value of the shares at vesting is ordinary income and subject to income tax withholding and payroll taxes. Employers will typically withhold by one of several methods: sell‑to‑cover (company sells some shares to cover taxes), withholding shares (company sends fewer net shares), or requesting cash from the employee to cover taxes. The employer reports the income on Form W‑2.

• NSOs (Nonqualified Stock Options): When exercised, the bargain element (difference between market price and exercise price) is ordinary income and usually subject to withholding and payroll taxes. Some employers will withhold a flat percentage or use supplemental wage rules at exercise.

• ISOs (Incentive Stock Options): ISOs can get favorable capital gains tax treatment if holding period rules are met. However, on exercise there may be alternative minimum tax (AMT) implications; employers generally do not withhold AMT. (IRS stock compensation guidance, https://www.irs.gov/retirement-plans/employee-stock-options)

Key things to know about stock withholding

• Withholding on equity is meant to cover ordinary income at vesting/exercise; it does not cover future capital gains when you later sell shares. Plan accordingly for potential capital gains taxes.
• The fair‑market value used to calculate ordinary income is the market price at vesting or exercise; employers must report that income on Form W‑2.

Practical example: If 1,000 RSUs vest and the market price is $25 per share, you recognize $25,000 ordinary income. If the company withholds 22% or sells 220 shares to cover taxes, you receive the net shares (or cash after sale) and will owe capital gain/loss on any change in price when you sell later.

Employee strategies for equity compensation

• Consider tax‑cover options the employer offers (sell‑to‑cover vs. withhold shares) based on your cash flow and long‑term goals.
• If you expect a big capital gain when you sell, plan estimated tax payments or increase withholding to avoid underpayment penalties.
• Work with a tax advisor before exercising large option blocks, especially for ISOs where AMT can be an issue.

Related resource: for help avoiding underwithholding throughout the year, see Federal Withholding 101: How to Avoid Underwithholding.

Tips: reporting, withholding, and employer responsibilities

Tips are both common and misunderstood. The IRS treats tips as taxable income, and both employees and employers have reporting and withholding responsibilities:

• Employee reporting: Employees must report all tips received to their employer if the total tips in a month are $20 or more. Typically employees record tips using Form 4070 (employee’s report of tips to employer) or an employer’s system. Reported tips are added to wages for income tax withholding and payroll taxes. (IRS: Tips — General Information, https://www.irs.gov/businesses/small-businesses-self-employed/tips)

• Employer withholding: Employers must withhold federal income tax, Social Security, and Medicare on reported tips and must match the employer portion of Social Security and Medicare. Large food and beverage employers must file Form 8027 to report allocated tips.

• Unreported tips: Employers can allocate tips to employees when reported tips appear low relative to gross receipts; employees who disagree can file Form 4137 (Social Security and Medicare Tax on Unreported Tip Income) when filing their tax return.

Practical example: A server receives $1,200 in tips in a month. Those tips must be reported to the employer. The employer adds the tips to the server’s wages for withholding calculations and payroll tax purposes.

Employee best practices for tip earners

• Keep daily written or electronic records of tips. Many modern POS systems can track tips automatically — retain those records.
• Report tips to your employer monthly if required; failing to report can trigger payroll adjustments and potential penalties.
• If you have significant unreported tips or disagreements with an employer’s allocation, document your records and consult a tax professional.

Common mistakes and how to avoid them

• Expecting take‑home pay for a bonus or vested stock equal to gross amount. Flat supplemental withholding, payroll taxes, and possible state taxes reduce that amount.
• Assuming withholding covers all future tax obligations. Withholding at vesting covers ordinary income tax; it does not prepay capital gains due when you later sell company stock.
• Not reporting tips promptly or underreporting. This can create payroll mismatches and tax penalties.

Fixes and planning tools

• Update your W‑4 to withhold extra if you anticipate supplemental wages will leave you underwithheld for the year. See our W‑4 guide above for step‑by‑step help.
• Make quarterly estimated tax payments if your withholding will not be sufficient. The IRS imposes penalties for underpayment of estimated taxes; paying quarterly can avoid that.
• For equity compensation, run a simple cashflow projection: estimate ordinary income at vesting/exercise and anticipated capital gains at sale to decide whether to increase withholding or make estimated payments.

Documentation and employer conversations to have

• Ask HR/payroll these explicit questions when you have supplemental pay or equity vesting: Which withholding method will you use? Will you offer sell‑to‑cover? Can you withhold an extra dollar amount? Will state tax be withheld?
• Keep copies of W‑2s, vesting schedules, exercise confirmations, and tip logs. These documents are necessary if you must explain income differences to the IRS or prepare an amended return.

Quick checklist for employees receiving supplemental pay

• Confirm employer withholding method before payment or vesting.
• Increase W‑4 withholding or make estimated payments if needed.
• Track tip income daily and report monthly as required.
• Consult a tax advisor before exercising large option grants or selling a big block of shares.

Authoritative sources and further reading

• IRS — Supplemental Wage Payments: https://www.irs.gov/newsroom/supplemental-wage-payments
• IRS Publication 15 (Employer’s Tax Guide): https://www.irs.gov/pub/irs-pdf/p15.pdf
• IRS — Tips (Report Tips to Your Employer): https://www.irs.gov/businesses/small-businesses-self-employed/tips

This content is educational and not a substitute for individualized tax advice. For guidance tailored to your situation — especially for large bonuses, clustered stock vestings, or significant tip income — consult a qualified tax professional or CPA.

In my practice, proactively forecasting tax consequences before a large bonus or equity event reduces surprises at filing time and keeps clients aligned with long‑term financial goals. Planning simple steps now — asking payroll how they will withhold and adjusting your W‑4 or estimated payments — can save a major headache and possible penalties later.