Assuming a deferred compensation plan is “non-qualified” (it is only offered to certain high-level employees and, thus, does not qualify for certain tax preferences), here is a brief explanation of how FICA and FUTA should be applied:
FICA actually includes two taxes: Social Security and Medicare.
The SS tax rate for 2010 was 6.2% for both the employer and employee. In 2011, the employer SS tax rate remains at 6.2%, while the employee SS tax rate is now 4.2%. SS tax is subject to a maximum income limit, which is $106,800 in both 2010 and 2011. As a result, SS tax is paid on only the first $106,800 of annual income earned by each employee in 2010 and 2011.
The Medicare rate for 2010 and 2011, for both employers and employees, is 1.45% (for a combined rate of 2.9%). There is no maximum income limit on Medicare; whether you make 100k or 1 million a year, you are subject to Medicare tax at a rate of 1.45% (combined at 2.9%).
FUTA is a single tax applied only to the first $7,000 of annual income earned by each employee. FUTA is only paid by the employer; it is NOT withheld from the employees’ wages. The tax rate is 6.2% on wages paid prior to July 1, 2011. As of that date, the tax rate will decrease to 6%.
Application to Non-qualified Deferred Compensation
Non-qualified deferred compensation, will be deemed to be subject to FICA and FUTA at the later of when the related services are performed or when there is no longer a “substantial risk of forfeiture” of the employee’s right to receive the compensation (basically, when the right to the compensation has fully vested).
When determining whether FICA (both SS and Medicare) and FUTA actually apply to the deferred comp, we must first look at whether the employee’s other regular wages (outside of the deferred comp) already exceed the applicable maximum income limit. If the employee has already exceeded the relevant income limits, no additional SS tax and no additional FUTA tax will result from the deferred comp. However, Medicare tax, which has no maximum income limit, will still be imposed on both the employer and employee at a combined rate of 2.9%.
Timing of Medicare
Assuming the employee’s income has already exceeded the maximum income limitations for SS tax and FUTA, the only remaining issue is the timing of the imposition of the Medicare tax. The employer has a choice on whether to withhold and pay the Medicare tax at the time of the deferral of the compensation or to withhold and pay the tax at the time of the ultimate distribution to the employee. If the Medicare tax is withheld at the time of the deferral (Year 1), the compensation is considered to have been “taken into account” as wages for FICA and FUTA purposes. Once it has been “taken into account” as wages for FICA and FUTA purposes, neither deferred compensation nor any earnings attributable to it will be treated as taxable wages when ultimately distributed (in Year 3, for example). Thus, if the FICA amount (often only the Medicare portion, as noted above) has been timely taken into account during Year 1, no FICA will be due on the ultimate distribution during Year 3.
The benefit of withholding in Year 1 is that the combined 2.9% tax will only be on the actual amount of the deferred compensation, rather than on the deferred compensation plus earnings that would have accrued through Year 3. The downside, however, is that the employer will be accelerating a cost that could have otherwise been deferred (although the cost will continue to grow during the deferral period).
Generally, I recommend determining the employer’s actual cost of withholding Medicare tax in Year 1 and comparing that amount to the projected cost in Year 3 (based upon anticipated earnings on that deferred comp over the next few years). The analysis must weigh the benefits of a smaller tax liability in Year 1 versus the benefits of deferring that cost to Year 3.