J. MARC FOSSE, July 28, 2022
Administering withholding and reporting of taxes under the Federal Insurance Contributions Act (FICA) for nonqualified deferred compensation plans maintained under Section 457 of the Internal Revenue Code (the “Code”) can be complex for many tax-exempt organizations. Employers frequently need assistance in setting up proper procedures and pay codes to implement timely and proper withholding and reporting of FICA taxes, which consist of both Social Security and Medicare taxes. Social Security taxes are withheld up to the applicable wage base ($147,000 for 2022), but Medicare has no wage base limit. This complexity stems from the fact that the timing rules for withholding of income taxes and FICA taxes are different. To explain this difference, this article initially provides a brief summary of the timing rules for income tax withholding applicable to 457(b) and 457(f) plans. Next, it reviews the special timing rule and exceptions for FICA tax withholding for nonqualified deferred compensation plans. Finally, it provides ideas and strategies for properly setting up and administering FICA tax withholding and reporting.
Income Tax Withholding for Code Section 457(b) Plans
There are two types of plans that can be established under Section 457(b) of the Internal Revenue Code (the “Code”) — governmental plans and nongovernmental plans. Governmental 457(b) plans are broad-based retirement plans that have many of the features of a 401(k) plan (such as rollovers and age 59 ½ minimum age for distributions), and the income tax withholding and reporting rules are also similar to tax-qualified plans. This article focuses on the rules applicable to 457(b) plans of nongovernmental entities.
Nongovernmental 457(b) plans (a “457(b) Plan”) can be maintained by certain tax-exempt organizations to provide deferred compensation to a select group of management or highly compensated employees. While not as flexible as a tax-qualified retirement plan, a 457(b) Plan permits executives to defer compensation until termination of employment, and sometimes beyond.
To qualify as a 457(b) Plan, the amount that may be deferred annually is limited under Code section 457(e)(15) — $20,500 for calendar year 2022 — and the amount is not increased by traditional catchup contributions.1 In addition, a 457(b) Plan is subject to required minimum distributions when a former executive attains age 72. Distributions from a nongovernmental 457(b) Plan cannot be rolled over to an “eligible retirement plan” or individual retirement account (IRA), but the plan may provide for a direct trustee-to-trustee transfer to the 457(b) Plan of another tax-exempt organization for which the employee is providing services.2
A 457(b) Plan can only be set up as an “account balance plan,” meaning the amount of the distributions from the plan will be equal to the monetary value of the account at the time of distribution. Contributions to a 457(b) plan may be made by participant deferrals or employer contributions. Generally, amounts contributed to a 457(b) plan are 100% vested,3 but the account balance is not included in taxable wages until “made available” (which generally means at the time of distribution) to the participant.
Income Tax Withholding for Code Section 457(f) Plans
Any nonqualified deferred compensation plan of a tax-exempt organization that does not meet the requirements of Code section 457(b) is treated as a plan subject to Code section 457(f) (a “457(f) Plan”).4 If compensation is subject to Code section 457(f), then the full present value of any deferred compensation will be included in income tax in the first year in which the compensation is no longer subject to a substantial risk of forfeiture (i.e., fully vested). Compensation deferred under a 457(f) Plan is subject to a substantial risk of forfeiture because the benefit will be forfeited unless the employee provides substantial services for a set period of time, or the employee or organization meet certain predetermined performance goals.
The general rule under Code section 457(f) is that deferred compensation is subject to income tax when it vests, even if the plan provides installment payments after vesting. The proposed Code section 457 regulations provide some exceptions to this rule, such as payments made within the “short-term deferral” period (defined below) or under a severance pay plan.
FICA Tax Withholding and Reporting
General vs. Special Timing Rule
Under the “general timing rule,” an amount earned is included in wages for purposes of FICA tax reporting and withholding when actually or constructively paid. There is a mandatory “special timing rule” for nonqualified deferred compensation plans. The special timing rule provides that the amount deferred must be included in FICA wages by the later of (1) the date the services creating the right to the amount are performed or (2) the date on which the right to the amount is no longer subject to a substantial risk of forfeiture (i.e., the vesting date). Therefore, FICA taxes are frequently due (and subject to tax withholding and reporting) before the income taxes are due on the deferred compensation at distribution.
Employee deferrals and employer contributions to a 457(b) Plan are almost always 100% vested. For that reason, FICA taxes should be withheld at the time services are performed to earn the employee deferrals or when an employer contribution is made. In order to maximize the amount deferred to the 457(b) Plan, FICA taxes are usually withheld from other wages, such as base salary. For example, if the employee elected to defer wages to the 457(b) Plan in the amount of $20,500 (the 2022 annual limitation), and if the employer reduced the amount of the deferrals by the amount of FICA taxes, then the net deferral to the plan would be less than the 457(b) Plan annual contribution level. For these types of vested contributions, the employer’s pay codes would generally include the contributions as Social Security wages up to the wage base (reported in box 3 of Form W-2) and as Medicare wages (in box 5 of Form W-2) at the time the deferrals or contributions are made. The Social Security withholding is reported in box 4 and the Medicare withholding in box 6 of Form W-2. Under this arrangement, the FICA taxes withheld must be deposited with the IRS under the employer’s regular deposit schedule for taxable wages in the payroll period. The FICA wages and withholding are reported on the employer’s quarterly employment tax return (Form 941).
If employer contributions are not vested, then the resolution date for withholding FICA taxes would be delayed to the date when each contribution becomes vested, which is usually still before the distribution date when income tax withholding would be made. For this type of contribution, the employer pay code requires the employer to enter and track each vesting date.
For amounts credited to a 457(f) plan, FICA tax withholding and reporting is required for any portion of the plan benefit that becomes vested. Under most 457(f) Plans, the benefit is also subject to income tax withholding and reporting as the benefit becomes vested. In that case, the timing rules for income tax and FICA tax withholding and reporting will be the same. However, there are exceptions. For example, the proposed Code section 457 regulations provide that if the payment must be made prior to the 15th day of the third month of the taxable year after the taxable year when the 457(f) benefit vests (the “short-term deferral period”), such a payment from a 457(f) Plan is not included in taxable income until actually paid.5 However, the value of the 457(f) Plan benefit is still treated as FICA wages on the date the benefit vests. In that case, similar to vested 457(b) Plan benefits, the employer would need to set up pay codes to have the 457(f) Plan benefits subject to FICA tax withholding at the time of vesting and income tax withholding at the time of distribution.
Under the non-duplication rule, once the FICA taxes have been withheld on nonqualified deferred compensation, then the deferred compensation will no longer be subject to FICA taxes again at the time of distribution. Importantly, interest or investment gains credited to the contributions that were previously subject to FICA tax withholding are not subject to FICA taxes at distribution, as long as the gains credited under the plan are based on a market interest rate or an actual investment. If the amounts credited to a 457 plan are based on non-market interest rates or investment options, then the gains credited to the plan are treated as new contributions that will be subject to FICA taxes.
The non-duplication rule is particularly important for contributions to a 457(b) Plan because the 457(b) benefit may be paid many years, even decades, after it is credited to the plan. Assume that an executive had deferred $87,000 of base salary over a five-year period and at the time of distribution twenty years later the contributions have grown to $205,000 based on reasonable investment returns credited to the plan. If the special timing rule has been properly applied, then at the time of distribution the amount of the investment growth ($118,000) will not be subject to FICA taxes. The employee and employer each save taxes in the amount of 7.65% (combined 15.3%) of the distribution amount related to investment option gains.
Because FICA and income tax withholding are generally triggered at the same time under a 457(f) plan, the non-duplication rule is not always applicable. However, as discussed above, if a payment under a 457(f) Plan is paid within the short-term deferral period, then the 457(f) Plan benefit is treated as FICA wages upon vesting, but not included for income tax withholding until paid. For example, if the benefit under a 457(f) Plan vests at the end of the employer’s June 30th fiscal year, and the payment will not be made until January 15th of the next calendar year, then distribution of the 457(f) account balance would not be subject to income tax withholding until the distribution date. If the 457(f) account balance increased in value between the vesting date and distribution date (based on reasonable investment options credited to the account), then the increase would not be subject to FICA taxes at distribution.
Rule of Administrative Convenience
The FICA regulations provide a “rule of administrative convenience” which permits an employer to elect to treat the resolution date as any later date during the same calendar year in which the resolution date would otherwise occur. Many employers select the last day of the calendar year, so that most employees will have already met the Social Security wage base and no Social Security tax withholding will be required. Medicare taxes will still apply. If the rule of administrative convenience is used, then the present value of the benefit must be determined at the time of the elected deferred resolution date.
Many employers also take advantage of the rule of administrative convenience to reduce the administrative burden created by the difference in timing rules between FICA and income tax withholding. To do this, the employer elects to treat all contributions to the 457(b) Plan or the vesting dates of a 457(f) Plan as occurring on December 31 of the calendar year. This may not only reduce administrative headaches, but also potentially reduce FICA taxes. Because 457 plans are “top hat plans” maintained solely for management and highly compensated employees, most participants will have already hit the Social Security wage base before the end of the calendar year. Using the rule of administrative convenience to delay the FICA tax resolution date to the end of the year, the employer will only need to treat the 457 plan contributions as Medicare wages. The employer would report the value of all contributions made to a 457 plan as Medicare wages on the employer’s fourth quarter Form 941 and in box 5 of the employee’s Form W-2. Because the amount of the Medicare tax is only 1.45%, this small withholding amount is usually taken from the participant’s base pay in her final paycheck of the calendar year.
Non-Compliance with Special Timing Rule Results in Application of General Timing Rule
The failure to adhere to the special timing rule (or one of the available alternative timing rules) would require withholding under the general timing rule. This would result in Social Security and Medicare taxes being withheld from each payment under the nonqualified deferred compensation plan. As discussed above, this would result in FICA taxes applying not only to the deferrals or contributions, but also to any investment growth credited to the account under the 457(b) Plan. At least one court has held that the employer committed a breach of contract for failing to use the special timing rule which resulted in significant additional FICA taxes. The court held that the participant did not receive the benefit of the bargain under the 457(b) Plan because of the material reduction in the net distribution of the participant’s account due to additional FICA taxes owed under the general timing rule. For that reason, if the tax withholding cannot be corrected (see below “IRS Correction Procedures for FICA Tax Failures”), then the employer may be liable for the employer side of the FICA taxes and the employee’s side plus a tax gross-up payment on the value of the additional FICA taxes the employer pays on behalf of the employee.
IRS Correction Procedures for FICA Tax Failures
To encourage self-correction of employment tax withholding and reporting errors, the IRS has established certain voluntary correction procedures for inadvertent employment tax withholding and reporting errors. During open tax years, an employer may file a Form 941X for the calendar quarter in which the FICA taxes should have been withheld. The statute of limitations runs until April 15th of the third year after the calendar quarter in which the original Form 941 was due to be filed with the IRS. Before end of the statute of limitations, the Form 941X must be filed no later than the deadline for the calendar quarter following the calendar quarter in which the employer discovers the error. Usually, the employer will also be required to issue a Form W-2c to the participant employee to correct the FICA tax withholding and reporting.
If an employer has failed to properly apply the special timing rule for 457(b) or (f) plans, then the employer should consult with counsel to determine if the failure can be corrected. Even if the failure cannot be corrected, it is advisable to consult with counsel to evaluate the risks associated with the failure and how best to resolve the issue with the affected 457 plan participant.
At the time an employer adopts a 457(b) Plan and/or a 457(f) Plan, we recommend that the employer also set up, in its payroll system or with its third-party payroll provider, the pay codes or other procedures controlling when FICA tax withholding and reporting will be accomplished. This will help the employer properly implement the timing rules for a 457 plan and avoid errors that are potentially very costly. Early set-up will also give the employer time to model and evaluate whether using the rule of administrative convenience would simplify the employer’s tax withholding and reporting obligations.
Our experience has shown that setting up these pay codes and procedures can take months to complete. This is because many payroll systems are not set up to handle the special timing rule or rule of administrative convenience, and often the third-party payroll provider is not familiar with these rules. In such cases, the employer must work with the payroll system vendor or third-party payroll provider to create customized procedures. Any delays in properly establishing pay codes and related procedures may result in late deposits and late reporting of applicable tax withholdings, which may trigger IRS penalties.
If an employer has inadvertently failed to comply with the special timing rule, the employer should consult with counsel regarding the IRS correction program or other actions to mitigate potential risks.
1 A 457(b) Plan may have very limited catch-up contributions. To qualify for catch-up contributions, the employer must look back and determine if the participant has not received full contributions in a prior year. If so, then in the three years prior to the participant’s retirement age, contributions can be made up to the lower of (i) two times the 457(b) contribution limit or (ii) the amount of the missed contributions in prior years.
2 The other 457(b) plan must also permit transfers into its 457(b) Plan
3 A contribution to a nongovernmental 457(b) plan is not considered by the IRS to be credited until the year in which the contribution is vested. To make the maximum contributions to a 457(b) plan each year, the amounts credited must be fully vested. A tax-exempt organization cannot make the maximum contributions to a 457(b) over a period of 4 years and require 4-year cliff vesting. This is because all the contributions would be treated as contributed in the final year, and would exceed the annual contribution limits for a 457(b) plan.
4 Certain programs are exempt from Code section 457(f), such as death benefits, vacation benefits and severance pay programs. See Proposed Treasury Regulations § 1.457-11(d) for pay that will meet the definition of an exempt severance pay plan.
5 The employer may have discretion when to make the payment during that period. However, the employee may not have any discretion to determine in which tax year the benefit will be paid.