Designed by Public Agency Retirement Planning, Inc.
Compensatory Time Payments to Retiring Employees
At many public agencies retiring employees are entitled to receive a cash payment based on accrued vacation, sick
pay and other types of compensatory time. This pay is taxed as ordinary income and is subject to FICA withholding.
For example, assume an employee who earns $65,000 annually and retires in June with a payment of $40,000 of
compensatory time.
Here is an illustration of the taxes she would pay on the $40,000:
Gross Distribution
$40,000
FICA - 7.65%1
$3,060
Federal - 27%
$10,800
State - 9.3%
$3,720
Total Taxes
$17,580
Take-Home Pay $22,420
Converting to a 401(a) Account
Instead of paying tax on compensatory time payments, the payments can be contributed into the employee's account
in a 401(a) plan.
Here's how it works: A defined benefit plan is adopted. Instead of receiving the $40,000 as wages the money is
contributed into the plan. All of the $40,000 is deposited tax-free as an employer contribution to a qualified plan. This
creates permanent tax savings for both the employee and employer of the 7.65% or $3,060 that would have gone to
FICA. The employer has a cash-flow savings of 7.65% of all contributions to the plan as compared to wage payments
in cash. In fact, since Social Security is an after-tax deduction the actual benefit to the employee is closer to 10% of
take home pay.
The employee then has the following options for the amount deposited in the defined benefit plan:
Transfer it into a 457, 403(b) or 401(a) plan if he has participated in one or more of these plans sponsored by his
employer.
Move it into a rollover IRA.
Take a cash distribution and pay normal income taxes.(Anyone under age 55 who receives cash from a qualified
defined benefit or defined contribution plan must pay 10% federal and 2.5% California excise tax).
All Cash Option
The unique advantage of this program is that even those employees who do not want any additional deferred income
can participate at a gain. If, when they terminate, they request a cash distribution from the plan or plans in which they
participate, they will save their share of the FICA.2
Flexible Plan Design
The plan can be tailored to individual groups of employees or bargaining units. For example, all employees under age
55 can be excluded (since they will have an excise tax if they take cash). The plan can be adopted for some
bargaining units and not for others. However, employees can never be given the choice, on an individual basis -- of
having their compensatory time contributed to a plan or paid directly to them -- because of Internal Revenue Service
restrictions. If the employee was counting on his final lump sum, he can still receive it, with the addition of the FICA
savings as a bonus
Summary of Benefits
In a time of budget deficits, this plan not only pays for itself but generates substantial savings for both the employer
and the employee. It also complements a plan for maximizing 457 contributions. The catch-up provision of Section 457
does not allow employees to utilize it during the last year of service. Therefore, the compensatory time payment, a
large lump sum that would have been the easiest for employees to save, is likely to be subjected to the highest
marginal tax brackets they will ever pay. If an employee was counting on his final lump sum, he can still receive it, with
the addition of the FICA savings as a bonus.
1 FICA consists of a Medicare tax of 1.45% on all wages and a tax of 6.2% on all wages up to $84,900.
2 The only exception is for employees under age 55.
