Avoiding Impermissible CODAs in Governmental Pension Plan Reform and Enhancement

One topic that frequently arises is whether a qualified governmental plan, under Internal Revenue Code (Code) Section 401(a), may allow an employee the election on whether to contribute at different pretax employee contribution amounts or even elect to participate in a different Code Section 401(a) plan which has a different pretax employee contribution amount. This article is intended to explain and address some of those frequently asked questions surrounding the cash or deferred arrangement, also referred to as a “CODA.”

Any election (whether it is direct, indirect, or the modification of a previous election) to receive taxable compensation not currently available or to defer the compensation into a trust or benefit plan, constitutes a CODA.¹ Such an election essentially asks an employee to choose between receiving compensation as a deferral (a pre-tax amount paid at a later date) or cash (a post-tax amount paid now).

There are two main scenarios in which a CODA can sneak into a qualified governmental plan: (1) benefit enhancements or reductions to existing plans, or (2) the creation of new benefit tiers and plan mergers or terminations. Nearly every governmental plan has or will face one or both of these scenarios. A survey conducted by the National Association of State Retirement Administrators found that since 2009, every state has made “meaningful changes to their pension plan benefit structures.”

There are two types of contributions that can be made to a pension plan: employer contributions and employee contributions. An employer contribution is an amount in addition to the employee's stated salary that is not taxable income for the employee until distributed from the plan.² In contrast, a contribution designated as an employee contribution must be included in gross income of the employee in the year the contribution was made. Employer contributions are therefore not treated as taxable to the employee, but employee contributions are made on a post-tax basis.³ This general rule is subject to two statutory or regulatory exceptions: the exception for picked-up contributions under Code § 414(h)(2), upon which this article focuses, and the exception for elective deferrals under Code § 401(k) (governmental employers may have grandfathered 401(k) plans). If a governmental plan designates the contributions of employees as having been picked up by the employer, “the contributions so picked up shall be treated as employer contributions.”⁴ Consequently, if a governmental employer correctly "picks up" employee contributions, such contributions will be treated for federal income tax purposes as employer contributions. This means that properly picked up contributions are excluded from the employee's gross income at the time of contribution and are not subject to federal income tax withholding.⁵

One of the requirements for a “pick-up” is that a governmental employer must not permit an employee to have a CODA election. A limited exception exists; however, permitting a one-time CODA at the time an employee first becomes eligible to participate in any plan that an employer provides.⁶ Any CODA election that does not occur upon initial eligibility is impermissible.

When considering plan design options, it is important to remember that if an impermissible CODA exists, the employee cannot exclude their pension contributions from income, and the plan’s qualified status may be jeopardized.

Mandatory employee contributions to a governmental retirement plan can be picked-up and treated as pre-tax contributions only if two conditions are met: (1) the plan requires the pick-up and (2) the employee has no election with respect to the amount or duration of the contribution after the employee's initial employment.⁷ In a series of private letter rulings (PLRs), the Internal Revenue Service (IRS) has identified limited exceptions where an employee election does not constitute a CODA:⁸

• Employer Mandate – the employer mandates a change in the contribution rate for all members under a plan (e.g., all employees are moved to a new tier or new plan with a different contribution rate, with no employee choice).
• Level Contribution – the employee contribution rate is the same across all applicable plans subject to the choice.
• Post-Tax Contribution – the lowest pre-tax employee contribution rate in a set of plans subject to an election is treated as picked-up (pre-tax), while any additional above that rate is treated as post-tax employee contributions.

How does this actually work? Can you give me an example?

Let’s explore these ideas through the lens of the hypothetical Miller United Retirement System, a qualified system in in the imaginary fifty-first state of Iceville that provides pension benefits to its government workers in its capital of Miller City. Like so many other localities, Miller City is struggling to recruit and retain qualified police officers and teachers, so the Iceville legislature has decided to examine its pension benefits.

Leo Plan 1, a qualified 401(a) defined benefit plan, provides pension benefits to law enforcement officers and firefighters, who are enrolled on their first day of work. Members contribute 5% of their salary on a pre-tax basis and are eligible to retire with a benefit of 2% of the average of their highest three years’ salary, multiplied by their years of credited service. Ten years ago, the Iceville legislature closed Leo Plan 1 to new entrants and enrolled new employees into Leo Plan 2, also a qualified 401(a) defined benefit plan. While contributions under Leo Plan 2 are also 5% pre-tax, the pension benefit is calculated at 1.75% of an average of the highest five years’ salary, multiplied by years of credited service. The Iceville legislature has convened its Benefits Committee to come up with proposals to modify the pension benefits available to Miller City police officers.

The Iceville legislature has come up with four suggestions to enhance benefits available in the Miller United Leo Plans and asked us to review them for federal tax concerns. The legislature will consult with Iceville’s Attorney General office to determine if there are state laws constitutional or labor law concerns with changing pension benefits for active employees.

1. Repeal Leo Plan 2, placing current Leo Plan 2 members into Leo Plan 1 and admitting new employees to Leo Plan.
   
   Here, because both Leo Plan 1 and Leo Plan 2 require a 5% pre-tax contribution that is picked up by the employer, there is no employee election to change the amount of compensation deferred. Additionally, because the employer is mandating the transition of all current Leo Plan 2 members into Leo Plan 1, there is no employee election as to plan participation. With no employee elections present, there is no CODA or federal tax concern with this suggestion.
2. Increase the multiplier in Leo Plan 2 from 1.5% to 2% and reduce average highest salary years from five to three but increase the mandatory employee pension contributions to 7% to pay for the enhancement.
   
   If the increased contribution rate is mandated by the employer and the Leo Plan 2 members are not given a choice regarding the change, no election is involved, and this proposal does not constitute a CODA.
3. Instead of mandatorily enhancing employee benefit calculation and increasing the contribution rates to pay for it, Leo Plan 2 members are given a choice to keep their benefit as is or to receive greater benefits in exchange for increased contributions.
   
   Once a choice is offered by the Iceville legislature, the additional contribution rate cannot be picked up because the election at the first time the employee was eligible to join the plan was for 5%. Therefore, additional amounts cannot be treated as picked up and excluded from income. If Leo Plan 2 members are able to elect to defer additional income in exchange for the enhancement, additional contributions must be post-tax. This means that if there is a choice to move from a 5% contribution to a 7% contribution, the 5% can still be pre-tax, but the 2% must be post-tax.
4. Enact a Leo Plan 3 with enhanced pension benefits and a higher employee contribution rate for new employees. The Iceville legislature also wants Leo Plan 2 members to be able to optionally elect to participate in Leo Plan 3. Leo Plan 3 will be a qualified 401(a) defined benefit plan.
   
   Because Leo Plan 2 members are given the option to pick between benefit structures, there is an impermissible CODA. Here, the Iceville legislature is going to leave Leo Plan 2 open for any members who do not elect to participate in Leo Plan 3. However, as discussed above, a governmental employee only gets one election to defer income at the time they first become eligible for any plan offered by their employer. This includes participation in any plan their employer may offer in the future. Therefore, if the contribution rates are different, a member who elects to participate in Leo Plan 3 can only defer 5% of their compensation (the rate in place for Leo Plan 2 upon election). Any additional contribution must be post-tax.

After the Iceville legislature addressed the Leo Plans in the Miller United Retirement System, they turned to teacher staffing issues in Miller City. Struggling to recruit new teachers to replace retiring teachers, the Iceville legislature proposed rehiring retired Miller City teachers who had a bona fide separation from service.⁹ They have requested an evaluation as to whether there are any federal law concerns with the following proposals. The Iceville legislature will consult with Iceville’s Attorney General office to ensure their ideas do not violate state laws.

1. Retired teachers, with a bona fide separation from service, may return to work. These retirees will have the option to cease receiving their retirement benefit and resume pension contributions, or to not contribute and continue receiving their retirement benefit.
   
   Effectively, the retiree is receiving an election to contribute 0% or contribute the mandatory employee contribution amount on a pre-tax basis. Like in scenario four with the Leo Plans above, a governmental employee gets only one election to defer income at the first time they become eligible for any plan that their employer offers. Therefore, if a retiree returns to employment with the same employer, the member cannot receive a new election regarding pension contributions. If the retiree is rehired by a different employer and has not previously participated in a plan with respect to the new employer, then the rehired retiree may receive a new election.
2. What if the Iceville legislature mandates retired teachers who are rehired back into participation with the Miller United Retirement System, but gives them a choice between joining the newly enacted defined contribution plan, rather than the original defined benefit plan under which they retired?
   
   Like in scenario four with the Leo Plans above, a governmental employee gets only one election to defer income at the time they first become eligible for any plan that their employer offers; this includes any plan their employer may offer in the future. Therefore, if the teacher is rehired by the same employer, the teacher may not choose between plans if mandated back into participation with Miller United Retirement System and the employee contribution rate between the two plans is different, unless the difference between the employee contribution rates is post-tax. However, if the employee contribution rate is the same between the two plans, the teacher could make a choice between the two plans and make pre-tax employee contributions.
3. Based on the options, the Iceville legislature decides to eliminate choice from the participation. The legislature has asked if it may mandate participation in the original plan or prohibit any participation.
   
   From a federal law perspective, as long as their plan permits it, the legislature may do either; however, Miller United Retirement System’s action must be consistent across all similarly situated employees.

Hopefully, creative thinking can help the Iceville legislature retain police officers and teachers in Miller City. 

^{[1] Treas. Reg. § 1.401(k)-1(a)(3)(i)
[2] Treas. Reg. § 1.402(a)-1(a)(1)(i)
[3] Id.
[4] Code § 414(h)(2).
[5] Treas. Reg. § 1.402(a)-1; Rev. Rul. 77-462, 1977-2 C.B. 358; Rev. Rul. 2006-43, 2006-2 C.B. 329. The IRS takes the position that picked-up contributions that are salary reduction contributions are taken into account as "wages" for FICA (Social Security and Medicare tax) purposes. If the picked-up contributions are paid by the employer in addition to the employee's normal salary or wages, the IRS has stated that they will not be wages for FICA purposes. Code § 3121(v)(1)(B).
[6] Please note that the term “plan” for CODA purposes does not include participation in a 457(b) deferred compensation plan offered by an employer.
[7] Revenue Ruling 2006-43.
[8] PLR 201529009 (Demonstrates one acceptable way to structure an election by making pre-tax employee contributions the same regardless of what plan is elected.); PLR 201532036 (Describes an employee choice process with different amounts of employee contributions depending on the employee's election. The conclusion is that to offer employees who are already participating in one plan an election to stay in that plan or go to another plan would be an impermissible cash or deferred arrangement.); PLR 201540014 (Outlines appropriate pick-up mechanics in a situation where there is no employee choice, but which would also apply if a choice exists).
[9] A bona fide separation from service means more than a termination of "covered employment." Instead, a bona fide separation from service means that the employee is no longer working for the employer, whether as a regular employee, a part-time employee, a seasonal employee, a contractual employee, an independent contractor, or a leased employee, etc. The IRS has issued both binding and non-binding guidance on the qualification requirement that there must be a separation from service prior to a distribution from a qualified plan. See PLR 201147038; see also Meredith v. Allsteel, Inc., 11 F.3d 1354 (7th Cir. 1993) (citations omitted) (concluding that the word "retire" is to be given its ordinary meaning and that "retire means to leave employment after a period of service."). For more information, please see our article on bona fide separation from service.}