Compensation and Benefits

Federal Tax Policy Relating to State and Local Government Retirement Plans

The Government Finance Officers Association is concerned over the effect federal tax policy and regulatory requirements are having on public employee retirement systems. Continual tax code revisions and the inclusion of public pension plans under rules intended for the private sector have caused great concern for state and local governments and their employees.

Two specific areas of the Internal Revenue Code (IRC) that place state and local governments in conflict with federal tax code requirements are the nondiscrimination rules of Section 401(a) and the maximum annual benefit and contribution limits found in Section 415. Failure to resolve these conflicts can mean the disqualification of plans, an extremely harsh penalty, resulting in the loss of tax-favored treatment for the employees' benefit accruals, contributions and the investment earnings of the trust.

Nondiscrimination Rules-IRC Section 401(a). The existing rules applicable to state and local governments are based on mathematical calculations that are designed to identify private sector benefit structures that disproportionally benefit high-income employees. When applied to public plans the type of benefit differentials that are identified are not between different categories of employees. State and local governments employ a wide variety of workers and sponsor multiple systems tailored to meet the needs of each group.

Maximum Annual Contribution and Benefit Limits (IRC Section 415). The Section 415 limits were enacted to cap the federal revenue loss associated with the employers' tax-deductible contributions to the employees' pension funds. Under these rules the allowable employee pension benefit can be dramatically lower than under the benefit formula of the state or local government pension plan. Basically, this is due to the restricted definition of compensation that is used in the federal tax code as opposed to what is included under state or local government statute. Furthermore, if state and local governments are forced to comply with the federal law, that is to reduce benefits, many will be in violation of their own laws that protect workers from reductions in benefits once they are in the employ of a jurisdiction.

Clearly state and local governments are caught in a dilemma. Failure to meet these federal laws that were designed to identify discriminatory practices in the private sector can result in the loss of tax-qualified status. If such an event was to take place, Congress' policy of encouraging retirement savings by workers and the providing of pension benefits by employers would be weakened.

A rational approach to applying the federal tax code to state and local government pension plans must be devised. GFOA recommends that all parties concerned--Congress, IRS, and the state and local government pension community--work cooperatively to make necessary revisions and modifications to and exemptions from the Internal Revenue Code.

  • Publication date: May 1990