Social Security and Deferred Compensation Plans
A reader from Los Angeles asks if contributing to a deferred compensation program lowers his Social Security earnings history.
"I am 63 years old, married and live in Los Angeles. I have been maxing out my 401(k) in preparation for retirement before age 65 and have $1.7 million saved. Over the last five years, I have also participated in a deferred compensation plan offered by my employer for mid-level and senior managers. My goal is to defer taxes on some of my $330,000 of annual income until I am in a lower tax bracket after retirement and to help bridge from retirement until I collect Social Security, most likely at my Full Retirement Age. I have $500,000 now in my deferred compensation account from contributions and some investment earnings. Do contributions to a deferred compensation program lower my Social Security earnings history and have the effect of lowering the Social Security payments I will receive?"
What I'm focusing on here is your $330,000 annual income. That's well in excess of the maximum Social Security wage base, which in 2021 is $142,800. Anything over that is not subject to Social Security taxes. Other withholding or payroll taxes – such as Medicare – have no income limitations so that the excess could be affected by them. But $142,800 is the maximum amount subjected to Social Security taxes, and your income is way higher than that.
You indicate you have $500,000 in your deferred compensation account and that you've contributed for five years. If so, I don't think you're deferring enough in any one year to push the wage you receive below that wage base number.
Essentially, you're maxing out your Social Security earnings history right now, even with the deferred comp. Another way to look at it is that, even if you took home that money rather than defer it, no additional Social Security taxes would have been collected.
Here's another reason you should be clear of any other Social Security implications: Social Security taxes are paid "on the way in" when the income is earned. And when you take the money out in retirement, there are no Social Security taxes. The assumption is that if there were Social Security taxes due, they would have been paid on the way in.
Some unique rules do apply to when Social Security taxes – or payroll taxes in general – are collected on deferred compensation. One rule, in particular, is called the Special Timing Rule.
Explaining this rule might be going beyond the scope of this particular question. However, because some readers participating in deferred comp may not have exceeded the wage base like you have ($330,000 is way above the $142,800 limit), they might be in the situation where there are Social Security ramifications for their deferrals.
If your earnings are close to that wage base number (like just over $100,000) and you're participating in deferred comp, then Social Security taxes may be collected on the deferred portion. However, they're collected either in the year that you earned it in the first place, which is the most common, or no later than in the year when there's no longer a substantial risk of forfeiture.
What is that risk? Deferred compensation can be lost for a variety of reasons or rules. But once you pass the date when there's any substantial risk of that, Social Security taxes become owed at that point if they're due, given the rest of your income situation.
But again, in your case, I think it's a moot point because there were never going to be Social Security taxes collected on any income above the wage base – above $142,800 in the case of 2021.
Here's the general rule: with rare exceptions, both the employee and the employer will participate one way or another in the Social Security taxation system, whether deferred compensation is involved or not. And, as an employee, choosing to defer is not going to undermine your Social Security benefit because you will likely pay any Social Security taxes on the deferred portion in the first place.
My answer could change if some elements of the story weren't shared, but I don't think so. Three factors are at play: you participated in the deferred comp for five years, there is not a massive amount accumulated, and your income was way above the wage base.
Congratulations on maxing out your Social Security participation every year, whether the deferral is considered or not. I don't believe you have any worries that your deferred compensation plan might undermine your Social Security work record.
Hopefully, I didn't complicate this answer too much, but I wanted to lay out that one possible exception – the Special Timing Rule. While it doesn't apply to you, it could apply to others. In that case, it can easily be looked up on the IRS website.