Government employees at the federal, state or local levels may enroll in a retirement plan covered by Internal Revenue Code 414(h) instead of the more familiar 401(k), 403(b) and 457 plans. A 414(h) plan (or "pickup plan") allows eligible government employees to defer some income by contributing to a tax-deferred account.
It differs from a 401(k) and similar arrangements in that it may allow employees to avoid paying FICA taxes (set at 7.65 percent in 2022) on contributions. When you see amounts labeled 414(h) in the "Other" box on W2 forms, it denotes the amount of income deferred through contributions to a pickup plan.
Read More: Form W-2: What Is It & Other Questions Answered
Anatomy of a Pickup
Both employers and employees contribute to a 414(h) plan. However, pickup plans get their name because the employer "picks up" employee contributions and treats them as if the company contributed the money. The importance of this maneuver is that it frees the contributions from an employee's FICA tax – that is, the payroll tax for Social Security and Medicare.
The IRS allows a pickup plan only if it satisfies specific rules:
- The employee's contribution must go directly into the plan, untouched.
- Plan members can't opt out of the pickup or receive contributed amounts directly.
- The employer must treat the deferred amount as a salary supplement instead of a salary reduction. This rule means that employers cannot reduce an employee's salary to offset the employee's contribution.
The IRS allows contributions to escape the FICA tax only to the extent that they would have been included in FICA wages but for the employee contribution.
Other rules apply, including the maximum annual contribution, either a percentage of the employee's income or a set dollar amount. Furthermore, the plan may mandate employee contributions. A 414(h) plan does not include any income restrictions, setting it apart from 401(k)s and IRAs. Employer and employee contributions are immediately 100 percent vested in a pickup plan. The standard early withdrawal penalty rules and required minimum distributions apply to 414(h) plans.
Effect on Tax Filings
Because your employer picks up your plan contributions, you don't report them on your tax return. You simply transfer the taxable income amount from your W-2 to your 1040 form. You pay less current tax because your contributions are tax-deferred. Furthermore, your contributions may be significant enough to drop you into a lower tax bracket, saving you even more money.
You must include plan withdrawals in your ordinary income for the year. By waiting until retirement to withdraw your money, you may benefit from a lower tax bracket at that time. On the negative side, your 414(h) contributions do not qualify for the Retirement Savings Credit available to taxpayers with incomes below set thresholds. In 2022, the credit can be as much $1,000 when filing single and $2,000 when filling jointly if your income is no higher than $20,500 ($41,000 for joint filers).
Read More: How to Calculate the Tax Credit for Retirement Savings
Effect on Social Security Benefits
Unlike 401(k) plans, a 414(h) pickup plan reduces your FICA earnings, i.e., the amount of income on which your Social Security and Medicare taxes are based. These 414(h) contributions save you money in the short run by reducing both your income tax and your FICA tax.
Still, they also may reduce the lifetime wages that the Social Security Administration uses to calculate your benefits when you later claim them. The upshot is that you could receive a lower benefit amount than you would have had you not reduced your Social Security earnings through a 414(h) plan.
Read More: Social Security & Retirement Age
Having a smaller Social Security benefits check each month might offset your enthusiasm for a 414(h) plan. However, you can take steps to reduce or neutralize the benefit reduction by investing your tax savings each year. For example, suppose you contribute $20,000 to a 414(h) plan when you are 40 years old. Your FICA tax savings that year is 7.65 percent of $20,000, or $1,530.
If you then invest those savings in an IRA, you may be in a position to supplement your reduced Social Security benefits at retirement. You can do this every year you participate in a 414(h) plan. The sum of your incremental IRA contributions (and their tax-deferred earnings) from your FICA tax savings might exceed your Social Security benefits reduction, giving you a net gain in retirement income.