In a tight labor market, effective recruitment and retention are paramount. One tool that employers can wield to woo and hold on to top-notch employees is what’s known as a tax gross-up. Here’s what you need to know about this approach for reducing your employees’ tax exposure and increasing their job satisfaction.
What is a gross-up?
The term “gross-up” refers to extra money you pay an employee to offset the additional income taxes they would incur on a taxable fringe benefit, so they ultimately receive the promised value.
Some employers also gross-up salary, typically for highly compensated employees. In this case, you’re essentially stating their salary as the take-home or net pay, as opposed to the more common gross pay—for example, an employee with a $200,000 salary is paid more to ensure they do, in fact, take home $200,000.
Note: The term “gross-up” also may be used to describe an arrangement regarding short-term or long-term disability insurance benefits. Rather than paying the premium and treating the payment as a deductible business expense, the employer increases the employee’s salary by the premium amount. It then deducts the disability premium from the employee’s after-tax pay and pays that amount to the insurance company. The employer deducts the amount of the “grossed up” pay as wages, and—because the employee has technically paid the premium with their own after-tax dollars—the benefits paid under the policy are tax-free.
When might you want to use a gross-up?
Employers usually use gross-ups for one-time payments, such as relocation expenses and bonuses. As noted above, an employer also might gross up for an employee who has a contract for a specific net salary. And employers that don’t offer a health insurance plan might gross up salary to give employees extra cash to purchase their own coverage.
What are some of the pros and cons for an employer?
Gross-ups can boost employee satisfaction by compensating workers without increasing their tax burden. It also provides a way to help with health costs, an important element in today’s compensation packages.
But providing a gross-up can establish expectations—rather than viewing it as a one-time thing, employees might expect such treatment repeatedly. This can get quite costly as your company grows when, for example, you’re giving annual bonuses to dozens or hundreds of employees.
Additionally, employers that gross up to help employees with their health costs might find it more affordable to buy a group health plan. Many employees prefer a formal health plan, so you could also enhance your recruiting by going that route.
What are some of the pros and cons for employees?
The benefits for employees are obvious—more money in their pockets, net of tax.
But a gross-up doesn’t necessarily eliminate all of an employee’s tax liability related to a non-salary payment. For example, under progressive income tax systems, grossed-up wages can push an employee into a higher tax bracket. Moreover, an employee might owe taxes on the gross-up amount (see examples below).
Note: Because employees may still have some tax liability after a gross-up, some companies refer to their tax gross-up offering as a “tax assistance program.” This can prevent unwelcome surprises for employees come tax time.
How do I calculate gross-up?
There’s no universal “right” way to calculate gross-up. Here are some of the most common methods. The proper approach will largely depend on your goals in paying a gross-up.
Flat rate method
The employer simply applies a flat rate to the net payment and adds the resulting amount to the payment. For example, you pay a flat gross-up of 30 percent. A $5,000 bonus would therefore result in a payment of $6,500 ($5,000 x 30 percent = $1,500 + $5,000)
With a flat rate, though, the additional gross-up amount will be taxable, so the employee won’t actually be made whole. In addition, this approach generally doesn’t comply with the regulations for withholding on so-called “supplemental wages,” or payments made to employees outside of wages.
Supplemental method
This method is based on the supplemental withholding rates set by the federal and some state governments. Those rates are first added with any other applicable tax rates. For example:
- The federal supplemental tax rate: 22 percent. If the supplemental wages paid to an employee during the calendar year exceed $1 million, the excess is subject to withholding at 37 percent (or the highest income tax rate for the year), without regard to information on the employee’s Form W-4.
- Social Security tax rate: 6.2 percent
- Medicare tax rate: 1.45 percent (2.35 percent if the employee’s wages exceed $200,000 for the calendar year)
- State supplemental tax rate (varies by state): 5 percent
Total = 34.65 percent total tax rate
The total tax rate is then applied to the desired net payment to compute the gross-up amount to be added. If, for example, you want to give an employee a $5,000 bonus:
$5,000 x 0.3465 = $1,732.50
The total payment would be $6,732.50.
As with a flat rate, the supplemental approach covers only the employee’s taxes on the underlying $5,000 payment—not the taxes on the gross-up amount.
Supplemental/inverse method
This approach is designed to compensate the employee for the extra taxes on the gross-up amount—in other words, it pays a gross-up on the gross-up.
Like the standard supplemental approach, you begin by calculating the total tax rate, which is subtracted from 1.0 to get the net percentage. Working from the above example:
1.0 – 0.3465 = 0.6535 net percentage
You then divide the desired net payment by the net percentage to get the total payment:
$5,000 / 0.6535 = $7,651.11
While the supplemental/inverse approach will usually be more accurate than a flat rate or straight supplemental method, it might not take into account the employee’s correct tax bracket. It also doesn’t reflect deductions, exemptions, or child credits.
Marginal/inverse
Like the supplemental/inverse approach, the marginal/inverse method compensates the employee for the additional taxes due to the gross-up. It’s more accurate, however, because it also incorporates the employee’s tax bracket and filing status.
To calculate the gross-up amount, you determine the employee’s estimated taxable income (considering only income received from the employee) without the net payment. Taxable income reflects deductions and exemptions but not child credits.
You use the estimate and the employee’s filing status to determine the applicable federal income tax rate from IRS tax tables. That rate is combined with the other applicable tax rates for the total tax rate.
From there, you apply the following formula:
Net payment / (1.0 – total tax rate) = Total payment
Consider an employee with $100,000 in taxable income who lives in a state with a flat, non-progressive 4.95 percent income tax rate and files as a single taxpayer. You want to pay him a $5,000 bonus.
Add up the applicable tax rates:
- 24 percent federal income tax rate
- 6.2 percent Social Security tax rate
- 1.45 percent Medicare tax rate
- 4.95 percent state tax rate
= 36.60 percent
$5,000 / 0.6340 = $7,886.44
Which approach should I use?
The marginal/inverse method should produce the most accurate results, leaving it less likely that the employee ends up on the hook for taxes because the gross-up payment wasn’t enough to cover their additional liability. Employers, however, often prefer the supplemental method because it’s much easier to both apply and explain. You should consult with a CPA to determine the best approach for your and your employees’ circumstances.
