Mandatory Employee Contributions to WRS: What’s a Governmental Employer to Do? (Hint: You May Need a Pick Up Resolution!)
By Mary Ellen Schill
April 1, 2011
As we wait for some sort of finality out of Madison relating to Wisconsin Act 10 (see our most recent alert “Implementation of Wisconsin Act 10 is Blocked Again by Dane County Circuit Court”), some governmental employers are already faced with the prospect of imposing mandatory Wisconsin Retirement System (WRS) contributions upon employees, due to recently implemented collective bargaining agreements. Others are preparing for a day when Wisconsin Act 10 (or some similar legislation) requires mandatory employee contributions from non-union represented employees.
The Department of Employee Trust Funds (ETF), which administers WRS, has already made it clear that any contributions that come from the salary or wages of employees, such as the contributions mandated by Wisconsin Act 10, are made on an after-tax basis, meaning federal, state, Social Security, and Medicare taxes are applied first, and then the required contribution amount is remitted to WRS.
ETF’s analysis has led it to the conclusion that there is nothing currently in Wisconsin Act 10 that would make the mandated employee contributions pre-tax. However, ETF has also indicated that if state law were changed, it “may be a means to make the contributions pre-tax rather than post-tax.” Further, ETF acknowledges that a local governmental employer “may be able to make the contributions pre-tax by developing a compensation agreement (as an example) between the employer and employees that complies with IRS criteria.”
What’s a governmental employer to do? What is the “IRS criteria” that has to be met in order for mandatory employee contributions to be made pre-tax rather than after-tax? To assist governmental employers with these questions, we offer the following Q&A’s.
Why aren’t these mandatory contributions pre-tax? Employees make pre-tax contributions to 401(k) plans all the time.
That’s true, 401(k) plans do offer employees an option of contributing out of their salary/wages on a pre-tax basis. The problem is, the federal tax code does not allow governmental employers to maintain 401(k) plans, and the WRS also does not (and arguably cannot) offer a 401(k) arrangement.
Isn’t WRS designed to have employee contributions?
Yes, WRS and the Wisconsin statutes that implement WRS do refer to employee contributions. This was true even before Wisconsin Act 10. However, in the vast majority of cases, employers (through bargaining or otherwise) have agreed to “pick up” these contributions by actually paying the contributions for the employees. This is allowed under the WRS and IRS rules. In the case where the employee is actually making the employee contributions out of his/her salary or wages, these contributions are made on an after-tax basis, unless the employer has adopted a pick up resolution, addressed in an upcoming question.
What is the impact on the employee of the after-tax contributions?
The impact on the employee is the federal and state taxes which the employee has to pay first, to arrive at the mandatory WRS contribution. For a single employee with a salary of $50,000, the mandatory employee contribution at 5.8% would be $2,900. Just looking at the federal taxes, assuming standard deductions and exemptions, in order to have $2,900 to remit to WRS, the employee actually has to earn $3,625, pay the federal taxes of $725, and the rest is deducted and remitted to WRS. State taxes will obviously have an impact as well.
What is the “IRS criteria” that ETF refers to which would solve this problem?
There is a section of the federal Internal Revenue Code (Section 414(h)) that provides a governmental employer can designate employee contributions to a retirement plan as being “picked up” by the employer, with the result being the contributions are treated as though paid by the employer for tax purposes. Combining that with the general rule that employer-paid contributions to a retirement plan are not taxable to the employee until the benefits are actually paid, this means that employer pick-up contributions are not taxable for federal (and Wisconsin) income tax purposes.
Hasn’t my governmental unit been “picking up” these contributions all along?
Yes, in the sense that someone says they will “pick up” the dinner check at a restaurant. And, unbeknownst to many employers, they have also been “picking up” employee contributions for tax purposes as well. Since WRS currently provides for employee and employer contributions, and historically the employer has been paying both, arguably the IRS all along could have taken the position that the employees were foregoing salary increases in exchange for the employer picking up the WRS contributions. The IRS is in the habit of taxing foregone salary because the IRS sees the employee as having received the salary and then purchasing the retirement contribution. It is only through the grace of IRS Code Section 414(h) that the employer’s pick up of the employee s contribution is treated as non-taxable, whether the employer is truly paying the employee s portion, or just designating the employee’s payment as having been paid by the employer under Code Section 414(h).
ETF says that the state could take care of this problem through a change in state law – is that true?
Yes, at the state level (through an amendment to the state statutes which govern WRS), the favorable tax treatment provided by Code Section 414(h) could be taken advantage of by all governmental employees who will be required to pay the mandatory employee contributions to WRS. However, Wisconsin Act 10 does not include the “magic” language at present.
Can we adopt this “magic” language and convert our employee’s after-tax contributions to pre-tax contributions?
Unfortunately, there is no specific IRS ruling directly on point that provides a clear, definitive path to treatment of WRS mandatory employee contributions as pre-tax rather than after-tax contributions. The IRS in 2006 issued a Revenue Ruling to a governmental employer (not a Wisconsin governmental employer) that has a similar fact pattern (state retirement system with mandatory employee contributions) and that allowed the governmental employer to adopt a resolution which specified that the employee contributions, although paid by the employer, were to be considered “pick up” contributions under Code Section 414(h). In order for this tax treatment to occur, the employer had to formally adopt a written resolution designating the contributions as being picked up by the employer, and the employees could not have the option to opt out of the “pick up” or to receive the contributed amounts directly (i.e. in cash).
In light of ETF’s acknowledgement that governments at the local government level could, after consultation with legal counsel, implement a program that satisfies the IRS criteria, we are advising our clients that short of requesting an IRS ruling, a local governmental employer could adopt a resolution (a “pick up resolution”) that satisfies the criteria set forth in the 2006 IRS Revenue Ruling, and take the position that the mandated employee contributions to WRS can be made on a pre-tax basis.
What about Social Security and Medicare taxes?
IRS rulings make it clear that assuming the Code Section 414(h) “pick up” treatment applies, any contributions made out of the employee’s salary or wages pursuant to a salary reduction agreement are subject to Social Security and Medicare taxes. Therefore, if the contributions are intended to be subject to Social Security and Medicare taxes (and therefore be used in determining those benefits), there should be a salary reduction agreement in place with the employee. We recommend a written agreement between the employer and the employee.
Can we get an IRS ruling that would apply to us?
Yes, but rulings can take up to a year. In the meantime we recommend the use of the “pick up” resolution discussed above.
What impact does this have on the employer?
Other than the cost of ensuring the employer’s payroll system can accommodate the pre-tax contributions (frankly it is possible that accommodating after-tax contributions can be more problematic), there is no additional cost (in the form of additional taxes) to the employer.
When does this resolution need to be adopted, and how?
The 2006 IRS Revenue Ruling requires the resolution be a formal action, by a person duly authorized to take such action with respect to the employing unit (presumably the governing body), and that the action can only apply prospectively (meaning it can only apply to compensation for services rendered after the date of the action). This means the resolution must be adopted before the beginning of the first pay period for which employee contributions are going to be deducted in order to be effective for that pay period. If the resolution is not adopted timely for that pay period, then the Code Section 414(h) tax treatment will not be effective until the next pay period.
What happens if the challenges to Wisconsin Act 10 are successful, and mandatory employee contributions are not required?
The resolution we would recommend would only be “triggered” if an employee is required to make a mandatory employee contribution by salary reduction to WRS. If mandatory employee contributions are never required, then the resolution is never implemented.
Anything involving the IRS and taxes makes me nervous. How can I make sure we’ve adopted the “magic” language?
Fortunately, we have attorneys within the Local Government & School District Focus Team who face IRS issues which impact employers on an everyday basis. We are ready to assist local governmental employers with drafting the necessary resolutions to implement a “pick up” contribution tax regime. If you have questions regarding the above, please contact Mary Ellen Schill, the author of this article, or any of the attorneys on the Local Governments Focus Team, or the School Districts Focus Team.
This document provides information of a general nature regarding legislative or other legal developments, and is based on the state of the law at the time of the original publication of this article. None of the information contained herein is intended as legal advice or opinion relative to specific matters, facts, situations, or issues, and additional facts and information or future developments may affect the subjects addressed. You should not act upon the information in this document without discussing your specific situation with legal counsel.
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