Compensation and Benefits

Maintaining Incentives for Retirement Savings

The Government Finance Officers Association (GFOA) supports the federal government's efforts to encourage private citizens to plan and save for retirement. State and local governments have also been responsible partners in providing for adequate retirement income for their employees. Presently, the vast majority of state and local workers participate in public employee retirement systems that provide sound, secure benefits in post-work years. As the Congress deliberates the issues of tax reform and deficit reduction, the social goal of maintaining a stable national policy regarding the tax treatment of employee pension benefits should be an overriding consideration.

Retain the Three-Year Recovery Rule

The proposed taxation of contributory pensions is in conflict with a strong national pension policy. Currently, local, state, and federal government employees are not taxed on their annuities until the retiree recovers his or her contributions made to the plan, if that recovery is no longer than three years.

Most public plan employees, unlike their private-sector counterparts, make pension contributions with after-tax dollars. Historically, the Congress has deemed it fair to allow individuals who had paid taxes "up front" on their pension plan contributions to recover them tax free within three years of retirement. On average, this recovery is accomplished within 18 months. The pension begins to be included in taxable income once it exceeds the individual's own contributions.

Since an employee's income is at its highest level when taxes are paid on these contributions, the ability to recover this cost immediately at the time of retirement on a dollar-for-dollar basis is a matter of basic equity.

Employees approaching retirement have utilized the three-year rule as a major element of their pre-retirement financial planning. Deferred compensation programs have been established in most states to encourage employees to accumulate personal savings for retirement. Since withdrawals from these programs are automatically taxed as ordinary income, elimination of the three-year rule will, in the future, create a major disincentive for employees to utilize these programs. Total repeal of the three-year rule at one point in time is particularly inequitable to employees who have participated in these programs and are within a few years of retirement.

Recognizing the devastating financial impact of this change on senior employees, it must be assumed that many individuals now eligible will elect to retire who would have otherwise remained in active service. This will create additional pension payments as well as productivity losses and training expenses at the very time when local, state, and federal governments can least afford them.

Preserve Current Distribution Rule

Additionally, the requirement that retirement benefits begin at age 70 1/2 presents a special problem for PERS. Unlike many private-sector plans, public plans allow additional benefit accruals beyond age 70. Implementation of this provision would result in a situation where an employee is being paid a retirement benefit and a full salary and at the same time earning additional retirement credits. This would obviously result in additional costs to state and local governments and would discourage the employment of older workers.

Retain 401(k)s for Public Employees

Another incentive to save for retirement should remain available to state and local government. The 401(k) is a valuable tool for encouraging retirement savings and for recruiting quality employees. The exclusion of public employers from maintaining 401(k) plans is unnecessary since the pending tax reform proposal would reduce deferrals by any amount contributed to an eligible deferred compensation plan commonly known as 457s. Therefore, the federal tax revenue foregone is kept at a fixed level, making no difference which deferred compensation plan is adopted.

For the reasons stated above, the GFOA opposes these changes contained in the pending tax reform bill that would adversely affect the distribution, taxation, and availability of retirement benefits for public employees.

  • Publication date: June 1986