Over the last couple of weeks I’ve blogged about the status of the social security payroll tax cut. If you’re catching up after a nice holiday break, the gist of the issue was whether Congress would extend the 4.2% social security tax withholding rate that was in effect for 2011 (in the end they did, for 60 days, through February 29, 2012.) Today, I explore some of the administrative considerations associated with the temporary extension of the payroll tax cut.

Administering Multiple Social Security Withholding Rates in One Calendar Year

Although the continuance of the social security withholding rate at 4.2% for another 60 days is seemingly good news for an estimated 160 million affected workers, there are some administrative areas that will need monitoring or adjustment. First, if the social security tax withholding rate changes mid-year (as is now scheduled to happen effective March 1, 2012), the maximum withholding amount for 2012 will be different for each employee, based on how much they earned before and after the rate change. This could be a challenge for software programs that cap social security withholding based on a maximum withholding amount, rather than wages.

Let’s look at some examples:

Employee A earns $20,000 in wages up through February 29, 2012. The same employee earns $100,000 between March 1 and December 31, 2012. In this example, his/her maximum withholding in 2012 is $6,426.00 ($20,000 x 4.2% and $90,100 (the $110,100 limit less the $20,000 already paid) x 6.2%).

Employee B earns $25,000 in wages up through February 29, 2012. This employee earns another $125,000 in wages between March 1 and December 31, 2012. His/her maximum withholding is $6,326.20 ($25,000 x 4.2% plus $85,100 x 6.2%).

Software programs that cap social security based on a maximum number will be looking to max people out at the same maximum amount across the board. As we can see from the examples above, the maximum amount of social security withholding will vary by individual. Be sure to check with your software provider or third party administrator to understand how social security withholding is calculated, and whether any work around will be necessary. The first two months of the year will be easy: you just withhold at the 4.2% rate across the board, up to the maximum of $4,624.20 ($110,100 x 4.2%). If Congress acts to extend the payroll tax cut for the entire year, none of the concern about the maximum withholding will matter. We’ll just simply apply the 4.2% withholding rate, up to the maximum of $4,624.20 for the entire year. However, if Congress does not extend the 4.2% rate and it reverts back to 6.2%, you may need to have some procedures in place to ensure that each person’s withholding reflects the correct maximum (again, it will be individually based, depending on what was withheld before and after the rate change). I’m already seeing postings in our discussion forum about this topic, so those who have ideas about how to administer this, please stop on by and share them.

A Tax Cut Recaptured

Also included in the legislation is a “recapture” provision that essentially recoups some tax dollars from employees who earn more than $18,350 by February 29th. Employees who earn more than $18,350 during the first two months of 2012 will be subject to an additional 2% in income tax (not additional social security tax). While it makes for a basically tax-neutral position for the employee (4.2% social security + 2% income tax = 6.2%, simply speaking), the company still needs to withhold at the lower 4.2% social security tax rate. This could be a key area of communication for employees who have significant income events in January and February (such as option exercises, RSU vestings, performance share delivery, etc.). How the 2% recapture tax will be collected is not yet entirely clear.

More Information

Lastly, the IRS has published notice IR-2011-124 with information regarding the payroll tax cut and recapture tax. In short, the new tax rate of 4.2% needs to be in effect by January 31, 2012, and any over withholding (for companies that went back to 6.2% in anticipation of the tax cut expiring) should be returned through an offsetting adjustment in pay as soon as possible, but no later than March 31, 2012.

It looks like our 2012 year is off to an interesting start!

– Jennifer