The Employer Pick-Up: Why it Matters
Legislation introduced in the Ohio legislature addressing the federal “employer pick-up” has raised attention concerning this complex section of the Internal Revenue Code (IRC) and why it matters to public employees’ retirement. NCTR wants to take this opportunity to explain the provision and how it could be threatened if “Rothification” of 401(k) plans were to advance in the Congress.
Simply put, the “employer pick-up” refers to a tax-deferral process contained in the IRC that allows public employees’ retirement contributions to their defined benefit (DB) plans to be made in pre-tax dollars.
What does this mean? Specifically, when an employee contributes to a retirement arrangement using pre-tax dollars, it reduces their taxable income for the year in which the contribution was made, thereby creating an immediate tax break because the employee will not pay income taxes on the amount contributed in that year. (However, the employee will still owe income taxes on the total amount contributed when it is subsequently withdrawn from the retirement account to pay retirement benefits.)
As the Internal Revenue Service (IRS) explains, generally, employer contributions to a retirement plan are not included in employee income. However, any additional contributions made by the employees are included in income, unless they are made under elective deferral provisions such as in a 401(k) plan. Therefore, in a DB plan, where, by definition, no deferral elections are permitted, governmental employee contributions would be included in employees’ gross income for taxation purposes, but for the employer pick-up.
That is, IRC section 414(h)(2), a special section of the tax code, provides that for any plan established by a governmental unit, where the contributions of employing units are employee contributions, but the employer is deemed to have “picked up” the contributions, the contributions are treated as employer contributions and are not included in an employee’s income.
However, for this to happen, i.e., for the employee contributions (including certain amounts withheld or otherwise offset from the employee’s salary) to be deemed “picked up” by the employer and therefore characterized as employer contributions, certain tests must be met:
- The employing unit must take formal action to provide that the contributions on behalf of a specific class of employees of the employing unit, although designated as employee contributions, will be paid by the employing unit in lieu of employee contributions.
- A participating employee, from and after the date of the “pick-up”, does not have the right to have a cash or deferred election right with respect to designated employee contributions.
- Participating employees must not be permitted to opt out of the “pick-up”, or to receive the contributed amounts directly instead of having them paid by the employing unit to the plan.
However, while these salary reduction pick-ups are the most common type of a pick-up arrangement, Audra Ferguson, a partner with the Indianapolis law firm of Ice Miller, a valued NCTR Commercial Associate member, explains there is a second type known as a “new money pick-up.”
In this kind of pick-up, the employer actually pays some or all of the employee contribution on behalf of the employee. For example, Ferguson says under the salary reduction pick-up, “if my compensation is $5,000 and my employee contribution rate is 10 percent, the $500 comes out of my gross pay and my net is $4500 (subject to other deductions/withholdings).” Under the new money pick-up, using the same situation, the employer pays the $500 to the plan on my behalf and my net is $5000 (subject to other reductions/withholdings).”
The new money pick-up “often is used with school superintendents or other highly compensated employees as a way to increase their total compensation,” Ferguson says. She also notes that “In most instances, plans only allow and employers only authorize the salary reduction type.”
The Ohio legislation in question – House Bill 473 — only deals with new money pick-ups, apparently, as it states that “The contributions required under this section shall not be paid by an employer on a contributor’s behalf, but may be treated as employer contributions for purposes of state and federal income tax deferred income provisions.”
Nevertheless, the reporter for Cleveland.com covering the legislation, Anna Staver, characterizes the bill in her headline as ending “pension pick-ups for public employees,” and describes the employer pick-up as “an obscure but lucrative perk,” when in fact it permits public employees to simply contribute to their primary retirement savings arrangement (a public sector DB plan) on a pre-tax basis in the same way that private sector employees can contribute to their primary retirement savings vehicle, the 401(K) plan.
As an indication that the legislation is aimed at new money pick-ups, Staver says the bill “would ban public employers from covering any portion of their workers’ pension contributions in future contracts,” which she calls “a practice sometimes used to sweeten deals for administrators and other top hires, where a school district or local government pays not only the employer share of a pension but part or all of the employee share as well.”
Once again, a salary reduction pick-up does not involve the employer actually paying an employee’s pension contribution but only being deemed to have done so for tax purposes.
Ohio Representative Dave Thomas (R-Ashtabula County) said the idea might sound generous but ends up being “flawed on a number of fronts” in his view, as it “lacks transparency for taxpayers, fuels bidding wars between local governments, and can lower an employee’s eventual pension benefit.” He believes that when taxpayers look at the compensation of an employee, they see their hourly pay rate. “The practice of picking up the employee’s pension boosts their compensation without full transparency,” he asserts.
This debate and coverage of the pick-up suggests that it is a complicated subject that can be easily misconstrued. This could play into the hands of opponents of the pick-up in Washington, DC, where the Joint Committee on Taxation (JCT) has previously urged repeal of the pick-up because of the inconsistent tax treatment of employee contributions to private and Federal DB plans compared to governmental employee pre-tax contributions.
Proposals requiring all or part of private employee contributions to 401(k) plans to be made in post-tax dollars (so-called “Rothification”) could bolster this argument for consistency, but to date, President Trump has opposed such a change. However, it can be scored as raising substantial revenues, so “Rothification” cannot be easily dismissed.
If “Rothification” of 401(k) plans is adopted, is it likely that public employees will be the only Americans permitted to continue to contribute to their retirement savings on a pre-tax basis?