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Payroll in Practice: 1.3.2022

Jan. 3, 2022, 7:01 PM

Question: Can a portion of supplemental pay, such as a bonus, be deferred under a 401(k) salary-reduction arrangement?

Answer: A 401(k) plan is a qualified retirement plan that allows for employer contributions that are exempt from Social Security and Medicare taxes and tax-deferred for income tax. In addition, a 401(k) plan provides for employee contributions on a salary-reduction basis that are tax-deferred for income tax purposes, but taxable for Social Security and Medicare taxes.

Because the plan is qualified, the employer contributions are also deductible by the employer for income tax purposes.

Employee elective deferrals are limited by overall contribution maximums and the employee’s compensation. The contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan increased from $19,500 for 2021 to $20,500 for 2022.

Employees aged 50 and over may make additional “catchup contributions” to these plans. The catch-up contribution limit of $6,500 for 2022 remains unchanged from 2021. That is, the maximum deferral for an employee aged 50 or older is $27,000 for 2022. In addition, the employee’s contribution may not exceed the employee’s compensation for the year if the compensation is less than $20,500, or $27,000 if the employee is age 50 or older.

The specific provisions of the plan may also limit contributions to a certain percentage of pay or to certain types of compensation, such as regular wages. An employer may want to limit employee contributions if the plan involves employer-matched contributions. Supplemental pay may be deferred only if the plan allows that type of compensation to be deferred.

Employer plans should be specific as to the types of compensation from which deferrals are to be made. A general provision that deferrals are to be made from, for example, “all compensation” or “supplemental pay,” may require deferral from compensation that the employer did not intend to be included, such as noncash fringe benefits.

If deferral of specific supplemental wages such as bonuses or commissions is allowed under the plan, the gross amount of the specified forms of compensation is subject to Social Security and Medicare tax withholding. However, the amount deferred is not subject to income tax or income tax withholding.

For example, an employee participates in a 401(k) plan that allows salary and bonus deferrals. The employee elects a salary deferral of 10% of gross pay. The employee receives a $10,000 bonus. The full $10,000 is taxable for Social Security, to the extent the Social Security wage base is not exceeded, and for Medicare tax, including the additional Medicare tax if applicable.

For income tax purposes, the bonus is reduced by 10% for the salary-deferral contribution, and only the remaining $9,000 is subject to income tax withholding and inclusion in current year income tax wages.

Question: An employee resigned recently. Due to the timing, final wages were erroneously overpaid by $2,000. The employee refuses to repay the overpayment, and we are sending it to collections. Are we responsible for the employer taxes? How do I handle this in payroll?

Answer: The employer does have a right to recover the overpayment. However, if an overpayment is not recovered, the overpayment, including withheld taxes, is treated as taxable wages to the employee. The overpayment is subject to employer taxes just as any other taxable wages. The $2,000 will be included in wages just as any other wages, and the Social Security and Medicare wages will be computed as usual, including the employer share.

If repaid before the end of the calendar year in which the overpayment occurred, all tax amounts, including employer shares — meaning income, Social Security, Medicare, and Additional Medicare taxes — can be adjusted to the correct amounts by amending the appropriate Forms 941. Any portion of the overpayment that is not repaid by the end of the calendar year remains taxable wages to the employee and employer for all tax purposes.

Once the calendar year end has passed, the employee must repay the gross amount including all withheld taxes. If a partial payment is made, it is treated as a repayment of a portion of gross pay including withheld tax.

For a subsequent-year repayment, whether in full or in part, the employer must refund to the employee any withheld employee Social Security and Medicare tax attributable to the amount repaid. This is so the employer may recover from the IRS the employee share of Social Security and Medicare taxes applicable to the amount repaid. The employer will also have to correct Forms W-2 and amend Forms 941 to report the changes to Social Security and Medicare wages and taxes for the period the overpayment occurred.

The employer may also recover the employer share of the taxes applicable to the amount repaid by the employee.

Income taxes and the Additional Medicare tax may not be adjusted after the end of the calendar year. The employee must still repay that part of the over payment to the employer. Any amount, whether net pay or withheld tax, that is not repaid by the employee remains overpaid and remains taxable wages to the employee.

Repayment in a subsequent year does not affect any payroll amounts for the subsequent year. That is, even if the overpayment is recovered through payroll deductions during the subsequent year, it is an after-tax deduction and does not affect the subsequent-year taxable wages or taxes.

From the employee’s standpoint, amounts repaid to the employer in a subsequent year remain taxable income for income tax purposes for the year of overpayment. Repayment to the employer does not result in an amended income tax return for that year. Instead, the employee may be allowed an adjustment on the tax return for the year the money was repaid. The income and Additional Medicare taxes withheld in the year of overpayment are applied as credits on the employee’s income tax return for the overpayment year.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, N.C., and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.

To contact the editor on this story: William Dunn at wdunn@bloombergindustry.com

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