4092 / How is a reduction in salary for a tax sheltered annuity treated for Social Security tax and income tax withholding purposes?

Excludable amounts paid into a tax sheltered annuity are not wages subject to income tax withholding, even if the amounts are derived from a salary reduction agreement.¹

The amount of salary reduction contributions to the plan is subject to Social Security taxes even though it is excludable from the employee’s gross income. Employer non-salary reduction contributions are not includable in wages for Social Security purposes.²

Under the final regulations, salary reduction agreement means a plan or arrangement under which payment will be made by an employer on behalf of an employee or his or her beneficiary under or to an annuity contract if the employee:

(1)  elects to reduce his or her compensation under a cash or deferred election;

(2)  elects to reduce his or her compensation pursuant to a one time irrevocable election made at or before the time of initial eligibility to participate in such plan or arrangement; or

(3)  if the employee agrees as a condition of employment to make a contribution that reduces his or her compensation.³

The Seventh Circuit Court of Appeals concluded that Congress intended IRC Section 3121(a)(5)(D) to include salary reduction agreements, whether voluntary or mandatory, in the FICA wage base. Accordingly, the Seventh Circuit held that payments made under a salary reduction agreement include salary reductions made under voluntary and mandatory agreements.⁴

Amounts contributed by salary reduction by a minister or by church employees whose organizations have chosen to be exempt from FICA are not treated as wages subject to Social Security taxes to the extent the contributions are not more than the employer contribution limit.⁵

Amounts of salary reduction treated as wages for Social Security tax are creditable to the individual’s Social Security account for benefit purposes.⁶