One of the primary benefits of nonqualified deferred compensation plans (NQDCPs) is income tax deferral.
Employee deferrals and employer contributions are not subject to current taxation, and benefits grow tax-deferred. Benefits are only subject to income taxation when they are distributed at some point in the future.
Unlike the straightforward rules for NQDCP income taxation, the regulations for Federal Insurance Contributions Act (FICA) taxes are more complex. The timing and size of FICA taxes can vary by plan type, form of contribution, vesting schedules, and other factors. This paper will provide an overview of FICA taxes and how they apply to NQDCPs.
FICA Taxes Overview
FICA taxes include Social Security and Medicare components. The total current employee tax rate is 7.65%. The Social Security portion (OASDI) is 6.20% on earnings up to the Social Security wage base ($168,600 in 2024), the Medicare portion (HI) is 1.45% on all earnings. Employers pay these same amounts as their portion of FICA taxes. Since 2013, single taxpayers with incomes over $200,000 and joint filers with incomes over $250,000 have been subject to an additional .9% Medicare tax. This additional tax is only paid by the employee, not the employer.
While FICA typically applies when compensation is received by an employee, a special timing rule exists under Internal Revenue Code Section 3121(v) that applies specifically to NQDCPs. Under these regulations, employee deferrals are subject to FICA immediately, as if the deferral amount had been paid in cash. However, employer contributions are subject to FICA at the later of when services are performed or when the deferred compensation is no longer subject to a “substantial risk of forfeiture.” This occurs most commonly when employer contributions become vested.
Special Timing Rule:
Defined Contribution vs. Defined Benefit Plans
The special timing rule is applied differently based on plan type:
Defined Contribution Plans
FICA taxation is relatively simple for defined contribution plans. Participant accounts are funded with employee and employer contributions, account values rise or fall based on pre-determined crediting rate methods, and benefits are paid at some point in the future. Employee deferrals are taxed as they are contributed, and employer contributions are taxed as they vest (including any gains or losses on contributions that become vested).
Defined Benefit Plans
Benefits under defined benefit plans are subject to FICA taxation when the deferred compensation is “reasonably ascertainable.” The regulations state that this occurs on the first date the amount of the benefit, the form of the benefit, and the commencement date of the benefit are known. In many cases these factors will only be known post-termination, such as when benefits are based on a percentage of final annual salary.
In these cases, FICA is paid after the participant has terminated employment. However, some defined benefit plans use a formula with more easily ascertainable future benefit amounts, such as when benefits equal a fixed dollar amount paid for over a set number of years at retirement. In these cases, the present value of ascertainable future benefits become taxable when they are earned and no longer subject to vesting during the year.
INDEPENDENT CONTRACTOR TAXATION
- No income or self-employment taxes are due when employee deferrals or employer contributions are made.
- Distributions are reported on Form 1099 MISC, and all taxes are due in the tax year of the distribution.
Non-Duplication Rule
Properly taxing FICA under the special timing rule can help minimize total FICA taxes owed due to the “nonduplication rule.” Under this rule, once deferred compensation has been taxed under the FICA special timing rule, the deferral amount and any earnings on this amount are never subject to FICA tax again in the future.
In order for earnings to be excluded from FICA taxation, they must be either be based on the returns of pre- determined investments or be based on a reasonable rate of interest. Many plans fall into the first category, where participants select options from a menu of deemed investments, and their account balances rise or fall based on the performance of their selected options. Unfortunately, the regulations don’t define what is “reasonable” under the second option. If a crediting method is deemed unreasonable under either of these tests, any return in excess of the midterm Applicable Federal Rate (AFR) will be subject to FICA taxation when it vests. Some sponsors have adopted the mid-term AFR as the crediting rate for their plans, since they feel its use as a benchmark for calculating excess returns adds to the argument it is “reasonable.”
Advantages of using the Special Timing Rule
Assuming earnings fit one of the two allowable definitions, following the special timing rule can result in far less FICA tax due than having benefits taxed under the “general timing rule.” Under this approach, all benefits are subject to FICA taxation when distributions are paid to the participant, including earning amounts that would have been excluded if the special timing rule had been followed. The additional taxable amount can be material.
Consider for example, a participant who defers $50,000 and the account grows to $200,000 over time. Under the special timing rules, only the initial $50,000 deferral is subject to FICA taxation. Under the general timing rule, both the participant and employer would owe FICA taxes on the full $200,000.
Conclusion
Understanding how FICA taxation applies to NQDCPs and properly administering plans according to any applicable special timing rules can have a significant impact on the FICA taxes owed on NQDCP benefits. Wrightwood will work with your organization to ensure that FICA taxation is optimized based on your specific plan design and crediting rate mechanisms.
