How Paid Time Off (PTO) Cash-Outs Are Taxed (2026)
When employees leave a company or cash out accrued vacation days, they are frequently shocked by how much smaller their payout check is than expected. This guide explains how the IRS taxes PTO cash-outs, supplemental withholding rules, and how excess tax is refunded.
1. Why PTO Cash-Outs Are Taxed Higher Upfront
When you take a paid day off while employed, your pay is disbursed as regular wages on your standard payroll schedule with your normal withholding rate.
However, when accrued, unused paid time off is cashed out—either upon resignation, termination, or annual company buy-back—the IRS categorizes the payment as supplemental wages under Treasury Regulation § 31.3402(g)-1. Supplemental wages include bonuses, commissions, severance, and accumulated leave payouts.
2. The Two Federal Withholding Methods for PTO
Employers must withhold federal income tax using one of two approved IRS methods:
Method 1: Flat 22% Supplemental Withholding
If the PTO payout is disbursed as a separate check or itemized distinctly from regular wages, the employer can withhold federal income tax at a mandatory flat rate of 22.00% (for cumulative supplemental wages under $1,000,000).
Method 2: The Aggregate Payroll Method
If the PTO payout is bundled together with your regular paycheck into a single lump sum, the payroll software combines both amounts and annualizes the total to calculate tax withholding. Because the check appears artificially massive, the system temporarily pushes you into higher tax brackets (24%, 32%, or 35%), taking a substantially larger bite from the check.
3. The Full Deduction Breakdown on a PTO Cash-Out
In addition to federal income tax, PTO cash-outs face mandatory payroll and state deductions:
- Federal Income Tax: 22.00% (flat rate) or aggregate payroll rate.
- Social Security Tax (OASDI): 6.20% (up to the $184,500 annual wage cap in 2026).
- Medicare Tax: 1.45% (plus 0.9% on earnings exceeding $200k single / $250k married).
- State Income Tax Withholding: Varies by state. States like California (6.6%), New York (11.7%), and Massachusetts (5.0%) apply supplemental withholding rates, while states like Texas, Florida, and Washington levy 0%.
An employee cashing out 80 hours of accrued vacation at $50/hour ($4,000 gross):
- Gross PTO Payout: $4,000.00
- Federal Supplemental Tax (22%): −$880.00
- FICA Taxes (7.65%): −$306.00
- California State Tax (6.6%): −$264.00
- California SDI (1.2%): −$48.00
Net Cash-in-Hand: $2,502.00 (37.45% total deduction rate)
4. Will You Get Overwithheld Taxes Back?
Yes! Withholding is not your final tax liability; it is merely an estimated pre-payment sent to the IRS. When you file your annual tax return (Form 1040), your total annual income—including the PTO cash-out—is reconciled against your actual tax brackets and standard deduction.
If your effective tax rate is 12% but your employer withheld 22% on your PTO cash-out, the excess 10% withheld is fully refunded to you as part of your tax refund.
5. State Laws Governing Mandatory Vacation Payouts
State labor laws differ dramatically regarding whether employers must pay out unused vacation when you leave:
- Mandatory Payout States: In California (Labor Code § 227.3), Colorado, Illinois, Montana, and Nebraska, earned vacation is legally considered wages. "Use-it-or-lose-it" policies are illegal, and all accrued PTO must be paid out on your final paycheck.
- Employer Policy States: In states like Texas, Florida, New York, and Georgia, employers are only required to pay out accrued PTO if their written employment handbook or contract promises it.
Estimate your take-home cashout using our PTO Payout Calculator (After Taxes).