A recently issued IRS private letter ruling (PLR) puts the kibosh on the fairly common practice of allowing public agency employees to elect whether and at what level to participate in the agency’s mandatory contribution pension plan.
This plan design stems from several PLRs issued in the early 2000s that implied, without explicitly approving, that such elections did not cause income tax problems for the participants or plan qualification problems for the employer. Basically, eligible employees were given a one-time, irrevocable election of whether to participate and, if participating, the specific level of mandatory (picked‑up) employee contributions the employee would make. In theory, if the employee mandatory contributions, which are normally after-tax, were properly picked up by the employer, such amounts would be treated as pre-tax contributions – not currently taxable to the employee.
In what to some of us is not a particularly surprising ruling, the IRS clarifies that:
1. Giving an employee the choice of receiving a certain amount of cash or contributing that amount to a retirement plan would generally constitute a cash or deferred arrangement within the meaning of the 401(k) rules.
2. Unless the adopting employer is eligible to maintain a “grandfathered 401(k) plan,” it is not possible for a governmental employer to offer such an arrangement as part of a tax‑qualified, or section 401(a), plan. Note, this ruling and discussion has no application to 457(b) plans of governmental employers.
3. Although there is an exception under the cash or deferred arrangement rules for irrevocable, one-time elections that are made “no later than the employee’s first becoming eligible under the plan or any other plan or arrangement of the employer,” this exception does not apply when the employees are already participating in another qualified plan (or 403(b) plan) of the employer – such as CalPERS.
The result of this ruling is that plans with this feature need to be carefully examined to determine how participants will be treated from an income tax perspective and how the plan itself may need to be restructured or fixed in order to maintain its tax-favored status.
Jeff Chang is a partner at Best Best & Krieger LLP. He has four decades of experience skillfully evaluating benefit and retirement plan compliance to achieve maximum outcomes for public agency clients throughout California. He can be reached at email@example.com or (916) 329-3685.