Federal Insurance Contributions Act (FICA) taxes on wages include Social Security’s Old Age, Survivors, and Disability Insurance (OASDI) and Medicare’s Hospital Insurance (HI). Tax rates as a percentage of taxable earnings are set by law and are currently 6.2% for OASDI and 1.45% for HI, payable each by employees and employers. (The 6.2% OASDI employee rate is temporarily reduced to 4.2% for 2011 and 2012.)
As a result of the Patient Protection and Affordable Care Act (PPACA), the employee HI tax will increase by 0.9% beginning January 1, 2013, from 1.45% to 2.35%. This will apply to FICA wages over $200,000 for individuals and $250,000 for married couples filing jointly. The employer tax rate will not change.
Accruals in nonqualified deferred compensation plans are also subject to FICA taxes, although the OASDI tax typically does not apply to these accruals because the non-deferred compensation of highly paid executives in nonqualified plans has usually exceeded the Social Security taxable wage limit ($113,700 in 2013). The HI tax has no maximum wage limit. Before the HI tax rate increase takes effect, executives may have a window of opportunity to save money with respect to taxes on their nonqualified benefits by paying some of the tax at the lower 2012 rates.
In a defined benefit (DB) nonqualified retirement plan (non-account balance plan), participants may voluntarily elect to pay the tax on their vested benefit before they retire. This is called “early inclusion” in the IRC Section 3121(v) regulations. The present value of the nonqualified benefit can be calculated at a date in 2012, and then taxes can be paid on that present value at the 2012 tax rate. When the participant retires in a later year, a “true up” calculation will be done to determine the final present value of the participant’s nonqualified benefit, and the excess of the final value over the originally calculated value is taxed at the rates in effect at the time of retirement.
It is important to note that the employee does face some risk in prepaying FICA taxes on nonqualified benefits. If the benefits decrease between now and retirement (because of growing offsets in the benefit formula, for example), the employee may overpay taxes. A larger risk for the employee is in the possibility that the company enters bankruptcy before he or she retires and the employee loses the nonqualified benefits that he or she has already paid taxes on.
For executives with sizeable nonqualified pension benefits, it may be worthwhile to consider taking advantage of the lower tax rates now by paying FICA taxes in 2012 rather than waiting until retirement. When making this decision, employees should consult their tax advisors, bear in mind how their nonqualified benefits may change between now and retirement, and take their companies’ financial stability into consideration. Plan sponsors should also consult with legal counsel before informing participants of the opportunity to pay FICA taxes early.