The income reported on your W-2 may differ for federal taxes and Social Security and Medicare because of the way the IRS treats payroll deductions. The IRS considers deductions relating to spending accounts for dependent daycare, medical and insurance premiums and commuter parking as pretax; they lower gross income for both FICA and federal taxes. A few pretax deductions are exempt from federal taxes but must be added back into your gross income for the FICA tax calculation.
Retirement and Education Savings
Contributions to 401(k), 403(b) and 457(b) retirement savings plans made through payroll deduction are exempt from federal withholding, but not the taxes you pay to Social Security and Medicare. The latter may appear on your pay statement as FICA, the acronym for the Federal Insurance Contributions Act. You pay the FICA tax when you make the contribution; you pay the income tax when you withdraw money from the plan. Building a college fund with pretax contributions to a 529 plan also saves you federal income tax, but your deduction is not exempt from FICA.
Executive Bonuses and Deferred Compensation
Any plan that lets you delay getting compensation or a bonus to minimize taxes also may delay, but not avoid, FICA taxes. When you pay FICA tax on deferred compensation bonuses depends on vesting requirements. If you must continue to work for a set period to earn the right to receive the money, you pay FICA taxes when that condition has been met; otherwise you pay FICA when the bonus or compensation is deferred.
Although they're not payroll deductions, fringe benefits cost you both income taxes and FICA taxes in some cases. The IRS defines fringe benefits as cash, property or services that your employer gives you in addition to your salary. You would pay FICA and federal income tax on the value of your company-paid group life insurance that exceeds $50,000, for example. If you use a company car for personal use, your employer must withhold FICA taxes on the value of this fringe benefit, but is not required to withhold federal income tax. Some employers include adoption assistance in their benefit package through which they reimburse employees for adoption-related expenses. The reimbursement is subject to FICA, but not federal income tax.
The income upon which you pay FICA tax is the same income used to determine your monthly Social Security benefit. Increasing your eligible deductions to pay less in FICA taxes may improve your cash flow now, but could mean lower Social Security benefits when you retire. According to financial planning expert Michael Kitces' blog, Nerd’s Eye View, someone who avoids $7,440 in FICA tax would reduce his annual Social Security benefits by more than $1,500 each year for life.
- University of Minnesota; Office of Human Services; FICA – Wage Limits and Tax Rates
- IRS.gov: 403(b) Plans
- IRS.gov: Nonqualified Deferred Compensation Audit Techniques Guide (02-2005)
- American Benefits Council: Update on the Taxation of Fringe Benefits
- IRS.gov: Group-Term Life Insurance
- IRS.gov: Publication 15 -- Employer’s Tax Guide
- New York University: Adoption Assistance Program
- Kitces.com: How Avoiding FICA Taxes Can Actually Cost You – Lower Taxes Can Lead To Lower Social Security Benefits