Income Tax Withholding on Elective Deferrals

[M_2015]

Employee elected 100% of pay to be contributed as pre-tax elective deferral.  The elective contribution would of course be reduced by payroll taxes, but can it also be reduced by income tax withholding?   Unique situation here where someone has a $10k supplemental wage payment, elected 100% elective deferral (which is permitted by plan).  Should there be income tax withholding on the amount of employee share of FICA & Medicare taxes, so as to reduce the elective deferral?  Is there authority for that, or should the elective deferral be equal to 100% of ($10k - EE payroll taxes).   

 

 

[Peter Gulia]

If a participant specifies a 100%-of-pay elective deferral, many employers and plan administrators interpret a plan to restrain such a deferral to what’s available after required withholding.

Here’s a simplified illustration, assuming no tax beyond Federal taxes, and assuming nothing else taken from the worker’s pay:

Pay before any withholding                             $10,000

Withholding for OASDI tax                            $620

Withholding for HI tax                                   $145

Net pay after withholding for wage taxes        $9,235

Federal income tax withholding (22% x $765) $168.30

Pay available for elective deferral                    $9,066.70

Elective deferral                                              $9,066.70

Net pay                                                            $0.00

I’m not aware of a particular statutory authority. Some might follow a principle that what otherwise would be a contract promise or obligation that would require a person to disobey applicable public law is legally unenforceable.

This is not advice to anyone.

[M_2015]

Very much appreciated!  The pre-deferral reduction for payroll taxes is very clear, and it's the federal income taxes that I'm struggling with.  Pre-tax elective deferrals up to the 402(g) limit are exempt from federal income tax withholding, so I suppose it turns on the interpretation of the plan document.  Mine allows elective deferrals up to 100% (for special payments, as here) of 414(s) compensation defined as 415 compensation, but also states that the amount of deferrals considers necessary adjustments under the company's payroll system.  That makes me wonder whether this justifies the income tax withholding on the employees' payroll taxes EVEN IF such withholding is not legally required under the applicable Code/Regs.  

[CuseFan]

I think Peter is correct and I think income tax withholding on such is legally required. I also wonder then, since the income tax withholding amount is also taxable income, doesn't that require withholding necessitating a circular calculation? 

That circular calculation yields $215.77 in income tax withholding that is equal to 22% of $980.77 ($765 + 215.77). However, I wouldn't split hairs on that and would accept whatever the payroll system delivered, provided it was at least Peter's details above.

Of course, if there is mandatory state income tax withholding then all this must be adjusted for that as well.

[Peter Gulia]

I assumed 22% because it is a default Federal income tax withholding rate for a supplemental wage payment.

Whatever the withholding for Federal income tax, the key to the solution is recognizing that the $765 withheld for OASDI and HI taxes counts in the employee’s Federal income tax wages, and so might bear some withholding for Federal income tax. Whatever the tax withholding is constrains the remaining net pay available for an elective deferral.

A regular pay likely would involve more complexities.

And a Roth deferral would add another layer of complexities.

Some employers set ordering rules to (1) account for all required or instructed tax withholdings; (2) account for garnishments; (3) order the kinds of amounts taken from pay (for example, taking a payment for health coverage before a contribution to a retirement plan); and (4) not allowing a period’s or supplemental wage payment’s net pay be less than $0.00 (or $1.00).

If an employer engages a payroll service provider, some have rules and controls of these kinds in the software.

This is not advice to anyone.