The 84-33 Special Timing Rule for FICA Taxation
Learn how FICA tax applies to deferred compensation based on vesting, not payment, and how this approach affects the taxable amount and future distributions.
Federal tax laws have specific provisions for when certain types of employee compensation are taxed. For nonqualified deferred compensation (NQDC)—compensation earned in one year but paid in a future one—the rules for Social Security and Medicare (FICA) taxes are distinct from income tax rules. The Internal Revenue Code establishes a “special timing rule” for these situations, creating a framework that impacts both employers and employees.
The Timing Rule for FICA Taxation
The “special timing rule” governs when NQDC amounts are treated as wages for FICA tax purposes. The rule dictates that compensation is subject to FICA in the later of two moments: when the employee performs the services to earn it, or when the compensation is no longer subject to a substantial risk of forfeiture. This latter event is known as vesting, and a substantial risk of forfeiture exists if the employee’s right to the funds is conditioned on future performance of significant services.
For example, an employer might grant an employee a $50,000 deferred bonus, but the employee only receives it if they remain employed for five more years. During that period, the bonus is subject to a substantial risk of forfeiture. Once the service requirement is met, the risk disappears, the amount vests, and it becomes subject to FICA taxes, even if the cash payment is scheduled for a later date.
This rule is not optional. The timing is often beneficial, as the tax may be calculated during years when the employee’s other earnings already exceed the Social Security wage base limit. Regulations also allow an employer to treat NQDC that vests during a year as taxable on any later date within that same calendar year to simplify payroll.
Calculating the Taxable Amount
The taxable amount is not the future payout itself, but the present value of that future payment at the moment of vesting. Present value is the current worth of a future sum of money, discounted to reflect the time value of money.
For instance, if an employee’s NQDC plan promises a $100,000 payment in ten years and it vests today, the employer cannot apply FICA taxes to the full $100,000. They must instead calculate the present value of that payment using reasonable actuarial assumptions and interest rates. This calculated present value is the amount included in the employee’s wages for FICA tax purposes in the year of vesting.
This calculation is performed when the benefit becomes reasonably ascertainable, which is straightforward for plans with a fixed payment amount and date.
The Nonduplication Rule
The “nonduplication rule” prevents deferred compensation from being taxed for FICA a second time when it is eventually paid. Once an amount of deferred compensation has been subjected to FICA taxes under the special timing rule, that amount is never treated as FICA wages again.
This protection extends to the principal amount taxed at vesting and any subsequent earnings credited to that amount. For instance, if the present value of a deferred amount was $60,000 at vesting and grew to $90,000 by payout, the entire $90,000 distribution is excluded from FICA wages. Both the original principal and its appreciation are shielded from a second round of FICA taxes.
An employer’s failure to correctly apply the special timing rule at vesting voids the nonduplication rule. In that case, the entire benefit distribution, including all earnings, becomes subject to FICA taxes at the time of payment, which can lead to a higher tax outcome.
Reporting on Form W-2
When NQDC vests and is taxed for FICA under the special timing rule, the calculated present value is included in the wages reported on an employee’s Form W-2. This amount is added to the employee’s other earnings for the year in Box 3 (Social Security wages) and Box 5 (Medicare wages).
The Social Security wage base limit applies, so if an employee’s total compensation already exceeds this threshold, no additional Social Security tax is due on the vested NQDC. However, since there is no wage limit for Medicare, the vested amount is always subject to Medicare tax. The vested NQDC is not included in Box 1 (Wages, tips, other compensation) in the year of vesting because it is not yet subject to income tax.
Employers may also report the amount in Box 11 (Nonqualified plans). This box is used to show distributions from an NQDC plan or to report amounts included as Social Security and Medicare wages under the special timing rule.