Minimize FICA Taxes in Nonqualified Deferred Compensation Plans

Nikki Kook- Marketing and New Business Coordinator

Minimize FICA Taxes in Nonqualified Deferred Compensation Plans

Nonqualified Deferred Compensation (NQDC) plans have become increasingly popular along with the higher income tax rates. A thorough understanding of the FICA special timing rule for NQDC plans is critical in taking full advantage of a NQDC plan’s tax benefits.

The Federal Insurance Contributions Act (FICA) tax for 2014 consists of a Social Security tax (6.2% rate for each of the employer and employee on wages up to $117,000) and a Medicare tax (1.45% for each of the employer and employee on all wages). Employees are also subject to an additional Medicare tax of 0.9% of wages in excess of $200,000.

NQDC plans defer income tax until the time of payment of the deferred compensation. However, the special timing rule requires FICA taxes to be paid at the time the NQDC amounts are deferred or vested. If these FICA special timing rules are not followed, NQDC amounts—including earnings on these amounts—are subject to FICA taxes at the time of payment.

Due to this special timing rule, FICA taxes generally apply to a NQDC plan before the taxpayer actually receives such amounts. Timing varies by plan type:

Defined Contribution Arrangements, or “account balance plans”: FICA taxes are paid when the amounts are deferred or when the participant becomes vested.

Defined Benefit Arrangements, or “non-account balance plans”: FICA taxation is delayed until the amount payable becomes “reasonably ascertainable”—generally when the participant terminates employment. The amount deferred is the present value of the future anticipated payments.

If the FICA special timing rule is followed, then amounts deferred—plus any earnings on the deferred amounts—are not subject to FICA taxes at any later date.

However, if the special timing rule for FICA taxes is not followed, the IRS interprets this to mean that FICA taxes will apply to the deferred amounts and all subsequent earnings when they are paid to the participant—resulting in higher FICA tax burdens for the employer and covered employees. In this case, FICA taxes—both Social Security and Medicare—would be paid each year the participant receives a benefit under the plan.

Ensure both employers and covered employees fully understand the special rules applicable to these plans for FICA tax compliance. Making adjustments to payroll and related systems and confirming the proper crediting of “earnings” will help minimize the amount subject to FICA taxation for both the employer and the covered employees. A win-win!

Related Articles:
FICA Taxes and Nonqualified Deferred Compensation—Fundamental Rules and Planning Considerations– AALU, 6/19/2014- DOWNLOAD HERE
Court Imposes FICA Special Timing Rule for Nonqualified Deferred Compensation– AALU 7/16/2014- DOWNLOAD HERE