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% $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:
1) 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.
2) Move it into a rollover IRA.
3) 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).
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.
NO ONE IS DISADVANTAGED BY THE PLAN, AND IT CREATES IMMEDIATE AND
DEFERRED TAX SAVINGS.
