Crunching the Numbers
FICA taxes consist of two types of taxes:
1) Social Security taxes up to a specified maximum threshold (referred to as the Social Security wage base, set at $118,500 for 2016); and
2) Medicare taxes on the entire amount of wages.
In general, FICA tax is imposed on wages in the year they are actually or constructively paid by an employer to an employee. However, a “special timing rule” under Internal Revenue Code (IRC) Section 3121(v) requires that wages deferred under a nonqualified deferred compensation plan must be taken into account the later of when services are performed or when there is no substantial risk of forfeiture of the rights to such amounts.
If the amounts deferred are subject to a substantial risk of forfeiture (such as a vesting requirement), FICA taxes are payable when this risk of forfeiture lapses. Due to this special rule, FICA taxes are generally applied to nonqualified deferred compensation before a taxpayer actually receives such amounts.
Defined Contribution Arrangements – Account Balance Plans
The special timing rule is fairly straightforward for defined contribution arrangements (referred to as “account balance plans”). FICA taxes are paid when the amounts are deferred, unless subject to a vesting schedule, in which case, FICA taxes are payable when the participant becomes vested in their account balance. As a result, FICA taxes, in essence, are paid up front and are not withheld from plan distributions.
Defined Benefit Arrangements – Non-Account Balance Plans
The special timing rule becomes somewhat more complicated in defined benefit arrangements (referred to as “non-account balance plans”), as the benefit payable to the participant may fluctuate and increase or decrease over time. FICA taxes could be overpaid if the benefit amount subsequently declines. The amount deferred for a period equals the present value of the additional future payment or payments to which the employee has obtained a legally binding right under the plan during that period. Reasonable actuarial assumptions and methods must be followed.
The interpretation of the special timing rule provides that FICA taxes become payable when the amount deferred under a non-account balance plan first becomes “reasonably ascertainable.” An amount is reasonably ascertainable as of the first date on which the amount, form and commencement date of the benefit payments are known, and the only actuarial factors or other assumptions regarding future events or circumstances needed to determine the amount deferred are interest and mortality. The exact definition is complex, and depending on the date for payment set under the plan at the time of deferral, this rule may result in the deferral of FICA taxation until the time of benefit payment or commencement (usually upon termination of employment).
There is an additional rule that allows employers to take amounts deferred under non-account balance plans into account for FICA purposes before they are reasonably ascertainable. This requires a true-up calculation to be performed at the time the benefit amount deferred becomes ascertainable. There are advantages and disadvantages for both the employer and the participant.
Does It All Add Up?
Benefit planning can quickly become overwhelming when trying to keep track of the evolving tax rules and regulations that must be followed. Employers who maintain nonqualified deferred compensation plans should consult with their tax and legal consultants to understand and comply with the rules for FICA taxation and make necessary adjustments to payroll systems to accommodate the rules for withholding.
This material is not intended to present an opinion on legal or tax matters. Please consult with your attorney or tax advisor as applicable.
This article originally appeared in the 2016 | ISSUE TWO of the SilverLink magazine under the title “Understanding FICA Taxes. Let’s Talk Tax.” To receive a complimentary subscription to the SilverLink magazine, sign up here.