Welcome to NCSSSA s webinar on Qualified versus Qualifying retirement plans.

Welcome to NCSSSA s webinar on Qualified versus Qualifying retirement plans. Just a bit of housekeeping before we get started--- Through Webex we can mute all participants so we don t hear all of your background noise. Even though we can t hear you, you can still ask questions throughout the presentation by using the Chat feature. Type in your questions and we will address them at the end of the presentation. 1

In today s session we hope our participants learn: The difference between Qualified and Qualifying retirement plans and how this information affects State Social Security Administrators. We also want to touch on some additional resources and support for State Social Security Administrators. 2

To give a brief idea of the topics we are going to cover, we will go over: State Social Security Administrator Role Withholding and Employment Tax Mandatory Social Security Qualified Retirement Plans Qualifying Retirement Plans Public Retirement Systems We want to be sure participants understand that the topics addressed in this webinar are critical components of Mandatory Social Security and can help State Administrators better serve their governmental employers. 3

First to introduce the State Administrator s role it helps to understand how the positions came into being.. A Section 218 Agreement is voluntary between the State and the Social Security Administration to provide Social Security and Medicare Hospital Insurance, or Medicare Hospital Insurance Only, to State and Local Government employees. Obviously, these agreements are called Section 218 Agreements because they are authorized by Section 218 of the Social Security Act. Each State has a designated official, the State Social Security Administrator, who is responsible for administering the State s Section 218 Agreement and its Modifications, as well as supervising the referendum process. The State Administrator provides public employers information about Social Security and Medicare coverage for State and Local government employees. The State Administrators are the liaison between their political subdivisions and the Social Security Administration and the IRS for coverage issues. Even though State Administrators are relied upon for a great deal of coverage information, it is important to also note that we should NOT dictate or influence our political subdivisions on retirement solutions for their employees. 4

A few basic concepts that are important to understand up front First, State and local governments are subject to the other employment tax known as FICA Federal Insurance Contribution Act which is commonly referred to as Social Security and Medicare. However, how and when this tax applies is different than in the private sector. Second--State and local governments are bound by withholding and reporting laws. They must withhold and report on taxable income. And--State and local governments are not subject to the unemployment tax known as FUTA Federal Unemployment Tax Act but might be subject to state unemployment taxes. 5

To realize the need for understanding our complex area of Social Security coverage, it is important to understand the history of the program. Prior to July 1991, for any political subdivisions to have Social Security coverage, they had to have a Section 218 Agreement. Congress changed that with implementation of what is called Mandatory Social Security which became effective on July 2, 1991. Beginning this date, state and local government employees became subject to Mandatory Social Security and Medicare coverage UNLESS they are (1) qualified participants of a QUALIFYING public retirement system, or (2) are covered under a Section 218 Agreement. Mandatory Social Security and Medicare coverage has many names--- Mandatory Coverage Section 210 Coverage Mandated by OBRA 90 (the Omnibus Reconciliation Act of 1990) and Federal Insurance Contributions Act or FICA Tax 6

One of the changes Congress made with OBRA 90, was they added a clause to Section 210(f) of the law that assigned the Secretary of the Treasury the responsibility to define retirement system exceptions through regulations. These exceptions from Mandatory coverage would be retirement systems that could not participate in Social Security coverage without a 218 Agreement. Hence the regulations were published by the IRS that coined the term QUALIFYING public retirement system. Essentially, coverage under Mandatory Social Security ceases when public employees become participants of a QUALIFYING public retirement system. Unfortunately, the choice in terminology has created confusion because of its similarity to another term often used by the IRS---QUALIFIED. The terms truly mean different things, so we are going to talk about the difference between QUALIFIED and QUALIFYING. 7

Let s look at the two terms in a general sense. QUALIFIED refers to specifications to be a public retirement plan. There are a variety of different retirement plans that meet the requirements for being a QUALIFIED plan, but not all QUALIFIED plans are QUALIFYING plans. QUALIFYING plans are specific to the regulations related to the exclusion from Mandatory coverage. 8

Let s first talk about QUALIFIED plans. 9

The Internal Revenue Code defines a QUALIFIED plan as a retirement plan that is established by an employer for the benefit of the employees. It provides tax breaks for the contributions the employer makes to a retirement plan for their employees. It reduces the employees income tax liability by reducing taxable income in the year of contributions to the plan. It allows employees to defer part of their paycheck into the retirement plan and not have to pay tax on it until the money is withdrawn. 10

A Qualified Plan gives a favorable tax treatment to its participants. The contributions made into the Qualified Plan are excluded from Taxable income. Along with that, the investment income (gains) are not subject to income tax in the year the gain is made. In turn, the participant pays tax on the distributions or withdrawals in the year the withdrawal is made. 11

Both Defined Benefit and Defined Contribution plans are subject to complex nondiscrimination and reporting requirements. Either type can be a Qualified plan. We are going to get into the differences between Defined Contribution and Defined Benefit plans later, but the general definitions are: A Defined Contribution is just as its name implies---the Contribution amount going into the retirement plan is a set amount or percentage of pay and can include an employer contribution as well as an employee contribution. The most common Defined Contribution Plans that we see in governmental entities are 401a; 403b for public education employers; and 457 plans. A Defined Benefit plan, as its name describes, is a retirement plan that defines the benefit a participant will get at retirement. While the contributions up front may be defined, the benefit is based upon a formula like average salary over the highest 36 or 60 months times a benefit factor often being anywhere from 1% to 2.5%. Other calculation methods do exist, but the important thing to realize is the definition is based on the benefit, not what is being put into the plan. 12

The Internal Revenue Code gives distinct definitions of allowable government plan types. A 401a plan is a plan established and maintained for employees of the US Government, a State, a political subdivision or instrumentality, and Indian Tribal Governments. As we discussed in the last slide, there are other plan types,. They include: 403b plans which are tax-sheltered annuity plans for public education and 501c3 employers; 457 plans, also known as Deferred Compensation plans; And other qualified excess benefit arrangements. There are also a few entities that have a 401K plan. However, unless the entity was grandfathered with a 401K plan before May 6, 1986, a government entity cannot now obtain a 401K. If they have a 401K but do not have the grandfather status, they need to convert their plan into an allowable plan type. There may be penalties involved, so have the entity s governing body consult their broker. 13

There are many points that are required in order to meet the IRS standard for a QUALIFIED plan. There must be: Exclusive Benefit Requirements Definitely Determinable Benefits/Written Plan Document The plan must operate in accordance with Plan Terms Section 401(a)(17) Compensation Limitation means there are limits to how much an employee can contribution annually, under certain circumstances There must be a minimum Required Distribution to meet the rules under Section 401(a)(9) There are Pre-ERISA Vesting Requirements in Section 411(e)(2) The IRS Code addresses Direct Rollover Requirements And there are Limitations on Contributions and Benefits in Section 415 14

What do all of those code sections mean? Well, a Qualified plan is a retirement plan that meets all the rules set out by the Internal Revenue Code and IRS Regulations, etc. It can be called a QUALIFIED Public Retirement System when it provides favorable Federal Income Tax treatment because it met all of the rules set out by the IRC, IRS Regulations and other federal and state regulations. 15

The bottom line? QUALIFIED refers to how the contributions and distributions are treated for Income Tax purposes. 16

Now let s talk about that other word---qualifying plans. 17

A point we want to make clear---as State Administrators, we have many terms that can mean the same thing. We often use the phrases FICA Replacement Plan or Social Security Equivalent Plan or Social Security Substitute that all mean a QUALIFYING plan. 18

Before you can understand the Term, you need to get a view of the history and evolution of the program. As we said before, political subdivisions paying into Social Security prior to July 2, 1991, could only do so by having a Section 218 agreement. Back then there was no distinction in retirement plans all retirement plans were treated the same for Social Security coverage purposes, no matter what type or level of contribution or benefit. With OBRA90, Mandatory Social Security coverage began covering those employees who were in positions NOT covered by a QUALIFYING retirement plan. OBRA90 required the IRS to define a QUALIFYING retirement plan. Any position NOT in a QUALIFYING retirement plan would be covered Mandatorily by Social Security. There are many interchangeable terms used for this concept. We use: Mandatory Coverage Section 210 Coverage Mandated by OBRA 90 Federal Insurance Contributions Act (FICA) Tax 19

As you can imagine, when Congress enacted OBRA 1990, many changes occurred. The most noticeable change for State and Local governments was, beginning July 2, 1991 and going forward, government employers not already covered by a 218 Agreement had to determine if their retirement plan offering met certain requirements to be a QUALIFYING plan so they could know whether or not they were legally covered by Social Security. Therefore, at any point after July 1991, the first question to ask is Does the entity have a 218 coverage agreement? If the answer is NO, then you would look at the retirement plan coverage to determine if positions are covered under Social Security through the MANDATORY provisions. In order to do that, look at the retirement system group to determine if the system or plan meets the QUALIFYING system guidance. If the plan is determined to be a QUALIFYING plan, then the retirement system members would need a 218 Agreement through a favorable coverage referendum in order to participate in Social Security. 20

For each position NOT covered by a 218 agreement, and when the retirement plan for which they participate is determined to be a QUALIFYING plan, then the positions covered by the retirement system are excluded from Mandatory Social Security coverage. That means each individual participating in the qualifying retirement plan must stop Social Security contributions because he or she has no legal means for coverage. Medicare contributions must continue for employees hired after April 1, 1986 no matter what the retirement plan situation. 21

Federal law requires that State and Local government employees must be covered by either Social Security OR a FICA replacement retirement plan. Don t be mislead by the terminology---a FICA Replacement Plan is just a coined phrase.it means a plan that has an equivalent benefit to what a Social Security retirement benefit would provide.. 22

To look at it from another direction--- The State or Local government employer is liable for the FICA tax unless it is providing a retirement plan that meets the standards set by the IRS to be a QUALIFYING plan OR The positions are covered by a Section 218 Agreement which would mean their wages would be subject to FICA. 23

Now to the meat of the matter--- Remember how we talked about the IRS being tasked with the responsibility for defining a QUALIFYING plan? The two places that the IRS fulfills their responsibility for determining a QUALIFYING plan begins in the Internal Revenue Code and is defined in Treasury Regulations. 24

The Internal Revenue Code Section 3121 b 7 F defines that a retirement system is ANY system or plan that is offered to employees. Note that the code goes on to refer to Whether a plan is maintained to provide retirement benefits with respect to an employee is determined under the facts and circumstances of each case. What that means is that any QUALIFIED retirement plan like a 401, 403, 457 are automatically fitting into the definition of a retirement system, however Social Security itself is not considered as a retirement plan benefit to employees for this purpose. 25

The IRS then went to the Treasury Regulations to get into the details of a QUALIFYING plan and how it must provide a minimum level of benefits compared to the Old Age portion of the Old-Age Survivor and Disability Insurance program of Social Security. It is really important to understand that the regulations specify that meeting the QUALIFYING status can be determined on an individual by individual basis. That is important when determining proper coverage with a 457 Plan. 26

The Treasury Regulation is where the IRS and SSA separate their definition of a retirement plan. If you remember, SSA policy doesn t care about QUALIFYING or not they see any retirement plan as a retirement plan for determining if the entity should obtain coverage through an Absolute Coverage group or a Retirement System group. If any type of retirement plan exists, then it is a Retirement System group. The IRS, however, must further separate SSA s generic retirement plan into whether or not it provides the minimum benefit comparable to Social Security. 27

Understanding the different regulations and guidance depends on the plan type. Remember we talked about these plan types earlier. A Defined Contribution is just as its name implies---the Contribution amount going into the retirement plan is a set amount or percentage of pay and can include an employer contribution as well as an employee contribution. The most common Defined Contribution Plans that we see in governmental entities are 401a; 403b for public education employers; and 457 plans. The IRS regulation that defines a Defined Contribution plan as a QUALIFYING plan sets a threshold for combined contributions to be at 7.5% or greater of compensation. That catch word here is COMBINED. This means the contributions in the plan are determined from both Employee AND Employer contributions. A simple example is where the Employer matches 3.5% if the employee contributes at least that much from his paycheck. This Employee contributes 4% so it now becomes a QUALIFYING plan for that individual. There can be many variations on the amount, but the key is AT or GREATER than 7.5% COMBINED Contribution amounts. 28

I can already hear you thinking But 7.5% is not equal to the 12.4% that gets contributed for Social Security. How can that be considered a FICA Replacement Plan? It is because the IRS was tasked with defining a QUALIFYING plan and their regulations do that very specifically for Defined Contribution plans. The 6.2% employee and 6.2% employer taxes are the current amounts required by FICA. However, Treasury Regulations 26 C.F.R. 31.3121(b)(7)-2 states, A defined contribution retirement system maintained by a State, political subdivision or instrumentality thereof meets the requirements of paragraph (e)(2)(i) of this section with respect to an employee if and only if allocations to the employee's account (not including earnings) for a period are at least 7.5 percent of the employee's compensation for service for the State, political subdivision or instrumentality during the period. Matching contributions by the employer may be taken into account for this purpose. 29

Now we ll move on to the DEFINED BENEFIT PLANS The difference with Defined Benefit plans is that their measurement for being a FICA Replacement plan is on the Benefit side instead of the contribution side. Most DB plans calculate a retirement benefit using a Highest Average Salary, along with the number of years of service, and a benefit factor. The Treasury Regulation 3121 addresses DB plans. It says that in order to meet the minimum benefit rule, the employee must have an accrued benefit under the system that entitles the employee to an annual benefit that starts on or before his or her Social Security retirement age that is at least equal to the annual Primary Insurance Amount the employee would have under Social Security. 30

That was all really convoluted and complicated and difficult for the average person to calculate. Does it mean we need to calculate the PIA or Primary Insurance Amount for each employee under the Social Security formula and then figure out the pension benefit and compare the two? Well, in a word---yes. Remember, the determination of being a QUALIFYING plan is made on individual-by-individual basis. Granted, that seems awfully burdensome, so there is some good news they are called SAFE HARBOR PROVISIONS. The IRS issued Revenue Procedure 91-40 as guidance for the standard plan types. It provides Safe Harbor formulas as measurements or thresholds for determining if a plan is a QUALIFYING plan. The Safe Harbor formulas utilize the benefit calculation formula based on the percentage rate used in the formula coupled with the number of Highest Average Salary Months, to set a threshold for whether the plan IS or IS NOT considered a FICA Replacement plan. Let s take a look at the Safe Harbor formulas--- 31

We already know the threshold for the DC plans is 7.5% combined contributions, but according to Rev Proc 91-40, for a Defined Benefit plan, the benefit formula of the plan must be at a certain percentage or greater to be a FICA Replacement plan. The Safe Harbor formulas define what IS a FICA QUALIFYING plan---in other words, if it does meet these thresholds then it excluded from Social Security without a 218 agreement. For plans that use the high 36 months (or 3 years) of average wages in the formula to calculate the retirement benefit, and if the percentage of the multiplier is 1.5% of the HAS or greater----then it is a FICA Replacement or a Qualifying Plan. Plans that use the high 37 to 48 months of average wages in the formula to calculate the retirement benefit, and if the percentage of the multiplier is 1.55% of the HAS or greater----then it is a FICA Replacement plan. Plans that use the high 49 to 60 months of average wages in the formula to calculate the retirement benefit, and if the percentage of the multiplier is 1.6% of the HAS or greater----then it is a FICA Replacement plan. Plans that use the high 61 to 120 months of average wages in the formula to calculate the retirement benefit, and if the percentage of the multiplier is 1.75% of the HAS or 32

greater----then it is a FICA Replacement plan. Plans that use the high over 120 months of average wages in the formula to calculate the retirement benefit, and if the percentage of the multiplier is 2% of the HAS or greater----then it is a FICA Replacement plan. If a plan does not use the formulas provided in the safe harbors, then it can still meet the minimum benefit rule if the benefit is at least as great as the accrued benefit the employee would have if his or her accrued benefit had been calculated under the safe harbor formula. 32

The guidance provided through Treasury Regs. and Rev Proc 91-40 focus only on the two predominant forms of retirement plans--defined Contribution and Defined Benefit. So, even though the guidance might be a little difficult, there is something to look toward for an answer. BUT, the retirement plan world has changed since 1991 when these were issued. There are hybrid type plans that feature different aspects of various plan types. Unfortunately, there is no official guidance for these newer types of plans. Should one of these plans be called into question, it might be necessary to ask the IRS for a Private Letter Ruling or to hire an actuary to see if the plan meets a minimum benefit test. If you or the entity does go with the actuary, it is always best to include the IRS in a final analysis so everyone will be on the same page. 33

So, now that we have reviewed the different types of plans, we hope that the terms QUALIFIED and QUALIFYING make more sense. Remember---QUALIFED refers to Income Tax treatment. QUALIFYING refers to the exclusion for state and local government employers for Mandatory Social Security coverage. 34

We have provided some additional resources that are helpful to State Administrators. The IRS Publication 963 can also be found as a publication search on the IRS website. The IRS also provides a Government Retirement Plans Toolkit that has many additional resources. The National Association of State Retirement Administrators, also known as NASRA has many good resources in their newsletters. And of course, the organization that has provided you with this webinar today, the National Conference of State Social Security Administrators, NCSSSA, who is always willing to assist with training and questions you may have on state and local government Social Security coverage issues. At this point, I ll leave these resources on the screen for you, but please feel free to continue to Chat in your questions and we ll answer what we can in the remaining time. 35