The Effect of Social Security Wage Base on the Decision to Maximize El

[Guest CAROLINE]

I am told that when a participant in a 401(k) plan has wage less than the limit for the social security wage base of $84,500 (i.e., @$72,000), the participant should not maximize the elective deferral because a reduction in the participant's salary would take it below the social security wage base would be best since employer contribuitons are not subject to employment taxes. Does this mean that the participant should not make the maximum elective deferral of $11,000 (and $29,000 for employer contribution so as not to exceed the annual addition limit) but instead, maximize the employer contribution (@$39,000 is availble to him)?

This does not make sense to me because while elective deferrals are included in the social security wage base, nevertheless, they reduce the income tax so is it not still better to maximize the elective deferrals?

Please, can someone explain it to me, a novice in the field? Thanks.

Caroline.

[Mike Preston]

It depends on your view of the value of the FICA taxes being paid.

If someone's compensation would be less than the wage base and the only issue is whether a single dollar becomes additional compensation which is then deferred, or, is contributed to the plan as an employer contribution, the numeric results are as follows.

Assume a total budget of $64,590.

Optioin 1:

a) Compensation is paid in the amount of $60,000

b) Assume that a salary deferral of $100 reduces taxable compensation to $59,900

b) EE FICA taxes of 7.65% = $4,590

c) ER FICA taxes of 7.65% = $4,590

Option 2:

a) Compensation is paid in the amount of $59,907.11

b) Assume that a company contribution of $100 goes directly into the plan

b) EE FICA taxes of 7.65% = $4,582.89

c) ER FICA taxes of 7.65% = $4,582.89

Assume marginal federal/state tax rate is 35%.

Employee paid income taxes on $59,900 in either event. In second option, employee paid income taxes on an additionl $7.11 in earnings. Therefore, employee paid an additional $2.49 in federal/state taxes

Employee receives $100 into a plan in either event.

Employer's outlay is the same. Employee's net check is now $59,907.11 - $4,582.89 - $2.49 = $55,321.73.

This compares to a net spendable of $59,900 - -$4,590 = $55,310 under option 1.

Of course, this employee's Social Security benefit is now taking into account only $59,907.11, not $60,000. Whether the reduction in Social Security benefits compensates or overcompensates for the increase in current cash to the employee can fuel a lively debate.

The above analysis only holds water if the individual is the owner of a company that is incorporated. The results are similar, but not the same if the employer is assumed to pay the same compensation, just vary the contribution between a regular employer contribution and a salary deferral. In this case, option 2 would likely change to:

Option 2b:

a) Compensation is paid in the amount of $59,900.00

b) Assume that a company contribution of $100 goes directly into the plan

b) EE FICA taxes of 7.65% = $4,582.35

c) ER FICA taxes of 7.65% = $4,582.35

Assume marginal federal/state tax rate is 35%.

Employee paid income taxes on $59,900 in either event.

Employee receives $100 into a plan in either event.

Employer's outlay is no longer $64,590. Instead it is: $64,582.35. Hence, the employer saves $7.65.

Employee's net check is now $59,900.00 - $4,582.35 = $55,317.65.

This compares to a net spendable of $59,900 - -$4,590 = $55,310 under option 1.

Of course, this employee's Social Security benefit is now taking into account only $59,900.00, not $60,000. Whether the reduction in Social Security benefits compensates or overcompensates for the increase in current cash to the employee can fuel a lively debate.

The third, and final scenario is when the individual is a sole proprietor or a partner. In this case, the individual gets a deduction for 1/2 of the FICA taxes paid. I'm out of time tonight, so does anybody want to do the comparison on that basis?

[MGB]

"Whether the reduction in Social Security benefits compensates or overcompensates for the increase in current cash to the employee can fuel a lively debate. "

If the person is older (e.g., 50 or over) and with low wages (e.g., under $35,000), then they should not be trying to decrease their FICA; the Social Security benefits lost are worth more than the FICA savings. (If in poor health and not expected to live to 85 like everyone else, then the FICA is worth more.)

If a person is a high wage earner or is young, the lost Social Security benefits are worth less than the FICA saved.

(This is only in terms of a comparison of FICA versus SS benefits; it does not take into consideration any changes in income taxes.)

[Guest CAROLINE]

Thank you so much for your help.

[Guest carsca]

I'm confused. Until now, I assumed that since 401(k) deferrals are counted as wages for FICA purposes, they are counted as wages for Social Security benefit purposes (see Section 215 of the Soc. Sec. Act). Thus, based on my assumption, when a participant makes 401(k) deferrals, the deferrals have NO effect on Social Security benefits. But, the discussion above assumes that 401(k) deferrals REDUCE Social Security benefits.

Am I wrong in my assumption? If yes, what authority states so?

[MGB]

You are correct that 401(k) deferrals have FICA on them and therefore are wages for determining the PIA, but you read the original posting wrong. The setup was a tradeoff between 401(k) deferrals and employer contributions to the plan, the total of which would max out at the 415 limit. By decreasing deferrals, they increase the employer contribution and vice versa. It is the employer contribution that is not accounted for in FICA and PIA.

[Guest carsca]

MGB,

Thanks for the clarification.