Interestingly, there is no requirement in the Federal Fair Labor Standards Act that employees must be given a vacation, either paid or unpaid. Unless required by contract (if any), the practice of granting some vacation time to an employee rests entirely within the discretion of the employer. Once time off for vacation is granted, the next question is whether it is PAID or UNPAID time off. This also is a decision for the employer.
However, since the granting of paid time off for vacation is so widely practiced, it may be helpful to review some of the issues which can arise with vacation pay.
Income Tax Withholding
Normally, vacation pay is subject to withholding as if it were regular wages. So, if an employee's entire 40-hour paycheck is for vacation, or if the 40 hours include 8 hours of vacation and 32 hours of worked time, the Federal income tax withholding is the same as if the employee had worked the full 40 hours.
However, sometimes employers are asked to include vacation pay in the last check before the employee actually takes the time off. Thus, the payment covers a greater time than that payroll period, and must be allocated over the payroll periods for which it is paid, with the withholding computed as if the payments had been spread out.
For example, Terri normally is paid $600 weekly, from which $66.61 is withheld. About to leave for a two-week vacation, Terri asks to receive a paycheck representing a gross pay of $1,800, which will include pay for the week of work just completed, plus two weeks' vacation pay. The correct Federal income tax withholding on the $1,800 is $199.83, equal to three times the amount withheld from a $600 weekly payment. In this example, if one were simply to process 120 hours worth of pay into a weekly pay cycle, the withholding calculation based on weekly tax tables would be $374.15. It is inflated out of proportion by the progressive nature of Federal income tax withholding rates.
Another type of vacation payment is the final pay out of unused vacation upon termination or retirement. In such cases, since the use of the vacation hours cannot be related to any particular payroll period, the vacation payment is subject to the Federal "supplemental wage" withholding. There is a choice of rules for supplemental wage withholding, as follows:
If the supplemental wages are paid together with the regular wages but the amount of each is not specified, income tax is withheld as if the total were a single payment for a regular payroll period.
If the supplemental wages are paid separately (or combined into a single payment and the amount of each is specified), the income tax withholding method depends partly on whether or not income tax was withheld from the employee's regular wages. If income tax was withheld from the regular wages, the employer can use one of the following methods for the supplemental wages:
Withhold a flat 25% for payments made on or after May 28, 2003 (no other % allowed), OR
Add the supplemental to the regular wages for the most recent payroll period this year. Then figure the income tax withholding as if the total were a single payment. Subtract the tax already withheld from the regular wages. Withhold the remaining tax from the supplemental wages.
Sometimes an employee agrees to work instead of taking vacation. In effect, such employees are choosing additional pay in lieu of time off for vacation. For withholding purposes, such vacation pay is treated the same as the pay out of unused vacation upon termination or retirement, discussed above. Thus, the employee is paid two times for the vacation period in question, and the vacation pay portion is taxed as supplemental wages.
Regardless of the method used to withhold income tax on supplemental wages, such payments are subject to Social Security and Medicare taxes, and FUTA tax. But, note that advance vacation payments, such as for Terri in the example above,