| Congress reduced the employee’s share of social security taxes by 2% (up to the taxable wage base) for 2011, and has maintained the reduction for at least the first two months of 2012. We are beginning to receive questions about how this affects pension calculations. The short answer is “very little." The Q&As below give the full answer:
Q-1: What is earned income for pension purposes?
A self-employed individual’s compensation for plan purposes is based on his or her earned income. In brief, earned income is net earnings from self-employment (NESE) from a sole proprietorship or entity taxed as a partnership in which the individual’s services are a material income producing factor. The plan deducts from NESE both (1) the Code §404 deduction for retirement plan contributions for the proprietor or partner, and (2) the 164(f) deduction.
Q-2: What is the 164(f) deduction, and what is its purpose?
For years, Code §164(f) has allowed a self-employed individual to deduct from adjusted gross income one-half of the self-employment taxes (SE Tax) the individual pays. This is designed to put an unincorporated business on an even footing with a corporation. Corporations can deduct the company’s share of FICA, which is one-half of the total FICA paid. The 164(f) deduction allows the individual to have the benefit of a similar deduction.
Q-3: What change in the social security tax rate has Congress passed for employees?
For 2011 (and at least the first two months of 2012), the employee portion of social security tax applicable to old age insurance (for wages below the taxable wage base of $106,800 in 2011 and $110,100 in 2012) is 4.2%. Normally the rate is 6.2%. The 2% reduction applies only to the employee’s portion of FICA. It does not apply to the company portion, which remains at 6.2%.
Q-4: Does this affect the Medicare tax rate?
No. The Medicare tax rate remains 2.9% (1.45% for both the employer and the employee) for all wages.
Q-5: How does this affect the SE Tax rate?
For 2011 (and at least the first two months of 2012), the SE Tax rate applicable to old age insurance is 10.4%. Normally the rate is 12.4%. This gives self-employed individuals the benefit of the 2% reduction in FICA taxes that W-2 employees receive (up to the taxable wage base). This rate applies on adjusted NESE up to the taxable wage base (reduced by W-2 wages). There is also a 2.9% Medicare component to the SE Tax which remains unchanged. Thus, the total SE Tax rate for 2011 is 13.3% of adjusted NESE up to the taxable wage base, plus 2.9% of adjusted NESE over the taxable wage base.
Q-6: How does this affect the 164(f) deduction?
For 2011, the 164(f) deduction will be based on 59.6% of the old age portion of SE Tax. The deduction applicable to the Medicare portion of SE Tax will remain at 50%. The reason for this adjustment is that the 164(f) deduction is designed to mimic the employer’s share of FICA, which does not change for 2011. Weighting the old age portion takes this into account.
For example, suppose a self-employed individual has NESE of $155,000 and no wages. In 2010, the individual’s SE Tax was $17,394 and the 164(f) deduction was $8,697. In 2011, the individual’s SE Tax will be $15,258, thanks to the change of rates, but the 164(f) deduction will be $8,695. Thus, the 164(f) deduction is only $2 less than it would have been in the absence of the rate change, even though the individual is saving over $2,100 in SE Tax. There is a difference, but the difference is trivial.
Incidentally, if the individual’s adjusted NESE is less than the taxable wage base, instead of breaking the tax into two portions, you can simply multiply the SE Tax by 57.51%. See Schedule SE.
Q-7: So, can I continue to use an earned income software solution which entirely disregards the 2% 2011 reduction?
If you wish to be precise, no, because software written to handle the calculation in 2010 will produce an answer that is slightly (at most $2) off the correct answer in 2011. As a practical matter, however, the results will be nearly equivalent. Only you can answer if “close" is “good enough" for you.
Q-8: When we calculate the SE Tax, one of the first steps is to multiply NESE by 92.35% to take into account the 164(f) deduction. That represents a reduction of 7.65%. Shouldn’t we multiply it by 93.35% (a reduction of 6.65%) instead?
No. The purpose of the adjustment is to mimic the employer’s share of social security and Medicare taxes, which has not changed. The 2011 Schedule SE continues to use a 92.35% adjustment. This follows what Congress enacted.
We will further discuss the self-employment tax in our January 31th Web Seminar, Earned Income: Computing Compensation for the Self-Employed. See below for more details and registration.
Upcoming Web Seminars:
Earned Income: Computing Compensation for the Self-Employed, January 31, 2:00 p.m. ET
ADP/ACP Testing Techniques – a 2-part program, February 1-2, 2:00 p.m. ET each day
Cash Balance Plans for 401(k) Practitioners - A 3-part program, February 7-8-9, 2:00 p.m. ET each day
For more information and to register online, visit our Web site.
Free Web Seminar
For those who attend our Practical Guide to Plan Fee Disclosures Workshop in January and February (see below), we will provide access (at no charge) to the recording of our Web seminar covering the final service provider fee disclosure regulations. Shortly after the final regulations are issued, we will e-mail attendees with instructions regarding how you can access the recorded presentation. The classroom Workshop, along with the recorded Web seminar presentation, will provide attendees with the necessary tools to help them comply with the regulations.
Practical Guide to Plan Fee Disclosures Workshop – January/February 2012. Are you ready to implement these rules in the next few months? Most practitioners would say – “no." That is where we can help. Using forms, case studies and examples, this workshop will provide you with the necessary tools and guidance to answer the tough questions and show you how to implement the regulations. For more details and to register online, visit our Web site.
Orlando Advanced Pension Conference – Early Fee Ends TODAY, January 17. Register now and Save $150. Loews Royal Pacific Resort at Universal Orlando® – February 15-17, 2012 – Earn up to 19 hours of CE credits. See the complete list of topics and register online on our Web site.
Just for ERPAs Workshop – February 14, 2012, Orlando, FL – Earn up to 8 hours of ERPA credit, including 2 ethics hours. Early bird discount ends TODAY, January 17. See event agenda and register online on our Web site.
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