FICA Replacement Plans

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Hello, and welcome to the Internal Revenue Service Phone Forum on "When is a Government entity and their employees excluded from participating in Social Security: FICA Replacement Plans". 

My name is James Driver and joining me today Lynette Thibodaux.  We both serve in the Federal, State, and Local Government Division within the Tax Exempt/Government Entities Division of the IRS.  We will be citing several regulations and we will repeat the citations so you can write them down for your reference.

This forum will be posted on our site along with a transcript.  Use the email address to request the link once it is posted.  te.ge.fslg.outreach@irs.gov Please use FICA Plans in the subject line.

Also, we will be discussing some FICA for government entities using a flow chart from Publication 963. You should have received it in an email yesterday. If you don't have the chart, please email us at te.ge.fslg.outreach@irs.gov  and we will send you one so you can follow along with us."

Today, we will discuss those other circumstances Government Employers and Employees don't participate in Social Security; namely FICA replacement plans. We will discuss Revenue Procedure 91-40 that sets forth rules relating to the minimum retirement benefit requirement prescribed under Employment Tax Regulations.

This presentation is not official guidance for your specific issues.  We are providing general guidance to help government entities understand the unique nature of FICA replacement plans.  If you have a specific question following this phone forum, you can go to IRS.gov and keyword search "FSLG Newsletter".  Within the newsletter you will see a list of FSLG Specialists for your State you can call and ask questions unique to your entity.  You can also sign up to receive the newsletter from this page.  In addition, you can email your question to te.ge.fslg.outreach@irs.govand we will do our best to address your questions.

Before we discuss FICA Replacement Plans, it may be helpful to discuss the ways in which a government employer and their employees do participate in Social Security and/or Medicare.

A government employer (when serving as the "Common Law" employer), is responsible for the appropriate social security and/or Medicare coverage.  Such coverage of the Government entities' current and/or future employees, under the Federal Insurance Contributions Act (FICA), social security and/or Medicare, is determined in three ways:

  1. Full FICA coverage, social security and Medicare, is extended through a voluntary plan and agreement through your State Social Security Administrator.  These agreements are commonly referred to as "Section 218" agreements. [Section 218 of the Social Security Act (Act)].
  2. For employment services performed after July 1, 1991, full FICA coverage, social security and Medicare, is a requirement for employees whose services are not covered under a Section 218 agreement or by a qualified, employer's retirement system. This coverage is commonly referred to as "mandatory FICA".
  3. Medicare only coverage is a requirement for political subdivision employees whose services are not covered for social security under a Section 218 agreement or under mandatory FICA, but who were hired after March 31, 1986.  This coverage constitutes Medicare qualified government employment.

Let's take a look at our decision tree or flow chart for Social Security and Medicare Coverage of State and Local Government Employees. This can also be found in IRS Publication 963 "Federal-State Reference Guide" on page 1-5.

First question on the flow chart: Is this position or service covered for Social Security and Medicare under a Section 218 Agreement?  If yes you withhold Social Security and Medicare, unless there is a position that is excluded within the Section 218 Agreement. 

If the answer is No, then you have to ask the question "is the employee a qualified member of a public retirement system?' (We will take a more in depth look at what a qualified member means later in this phone forum).  If the employee is not a qualified member of a public retirement system then you withhold Mandatory Social Security and Medicare, unless some exclusion applies.

If the answer is yes the employee is a qualified member of a public retirement system, then you have to determine if the employee is in a position that is covered by a Section 218 Agreement that provides Medicare-only coverage for employees hired prior to April 1, 1986.  If the employee is a qualified member of a public retirement system and is covered for Medicare by a Section 218 Agreement then you would withhold Medicare for that employee unless an exclusion applies.  However you would not withhold Social Security in this instance.

If in this instance there is no Section 218 Agreement for Medicare-Only, then would the Medicare Continuing Employment exception apply?  If yes, then no Social Security or Medicare is withheld.  If the continuing employment exception does not apply, then you withhold Medicare only for all hires after March 31, 1986.

The Section 218 Agreement trumps all aspects of Social Security and/or Medicare coverage.  It is important to understand whether or not your entity has coverage under a Section 218 Agreement before deciding if your retirement plan qualifies as a FICA replacement plan. To do so, you may want to contact your State Social Security Administrator whose contact information can be found at NCSSSA.org

If a government entity does not have a Section 218 Agreement, then does that entity have a qualified, employer's retirement system?  Under section 3121(b)(7)-2(e) of the regulations(repeat), a retirement system generally includes any pension, annuity, retirement or similar fund or system within the meaning of Section 218 of the Social Security Act that is maintained by a state, political subdivision or instrumentality thereof to provide retirement benefits to its employees who are participants.

However, the definition of retirement system is limited. Under the regulations, in order to work for a state or local government entity and qualify for exemption from Social Security for wages earned – the employee must be a member of a retirement system that provides certain minimum retirement benefits.

If the government entity does not have a Section 218 Agreement and it does have a retirement plan in which an employee participates that meets the minimum retirement benefits, then the employer and employee may be exempt from participating in Social Security only. 

Remember all employees hired after March 31, 1986 are covered under mandatory Medicare.  Yet it is possible that employees hired before March 31, 1986 are covered for Medicare if the employer has a Section 218 Agreement coverage for Medicare only.  Again you will want to contact your State Social Security Administrator for more information.

Generally retirement plans fall into two categories: Defined Contribution and Defined Benefit.

A defined contribution plan provides an individual account for each participant and provides benefits based solely on the amount contributed to the participant's account.  A defined contribution plan that satisfies the definition of a retirement system must provide for an allocation to the employee's account of at least 7.5 percent of the employee's compensation during any period under consideration.

A variety of plan types could meet the requirement: for example, plans established under Internal Revenue Code sections 401(a), 403(b) or 457. Contributions from both the employer and the employee maybe used to make up the 7.5 percent.  Employer contributions can be calculated with employee contributions to reach the 7.5 percent. 

A plan with only employee contributions would also satisfy the minimum benefit requirement, provided contributions constitute at least 7.5 percent of compensation.  However, the 7.5 percent cannot include any earnings on the account.

Earnings or compensation is considered "base pay" as long as "base pay" is reasonable.  A defined contribution retirement system may disregard overtime pay, bonuses, and/or single sum amounts received on account of death or separation from service, amounts received under a bona fide vacation, compensatory time or sick leave pay plan, or funds received under severance pay plans. 

Any compensation in excess of the social security maximum wage base for that particular year may also be disregarded for this purpose.  For example, for tax year 2013, the social security maximum wage base is $113,700.

Generally, for an employee who holds more than one position with the same employer, all compensation with that employer is considered in applying the 7.5 percent test.  However, at the employer's option, compensation from only one position may be considered, if that position is not part-time, temporary, or seasonal. We will discuss part-time, temporary, or seasonal later in this "forum".

A defined benefit plan (for purposes of determining whether it qualifies as a public retirement system), is any plan other than defined contribution plan. A defined benefit plan determines benefits on the basis of a formula, generally based on age, years of service, and salary level. 

A defined benefit retirement plan system that qualifies as an alternative to social security provides for a retirement benefit to the employee that is comparable to the benefit provided by the social security part of FICA.  Generally, a plan meets the requirement if the benefit under the system is at least 1.5 percent of average compensation during an employee's last three years of employment, multiplied by the employee's number of years of service.

A defined benefit plan has safe harbor formulas that use the Final and highest average pay formulas of 36 months or less at 1.5%.  Revenue Procedure 91-40 provides the formula for calculating benefits for periods more than 36 months (or 3 years).  

  • 37-48 months 1.55%
  • 49-60 months 1.60%
  • 61-120 months 1.75%
  • Over 120 months 2.0 %

What does this mean for Social Security participation purposes?  If a government entity meets the safe harbor rules as participating in a defined benefit plan, then they have a "FICA replacement plan".  In short, if the government entity does not have a Section 218 Agreement and the retirement system plan meets the Revenue Procedure 91-40 safe harbor rules the government entity and the employees do not participate in Social Security.  (Although anyone hired after March 31,1986 would participate in Medicare).

Earlier in this presentation when we were discussing the flow chart for Social Security coverage we used the terminology qualified member of a public retirement system.

Who is a Qualified Participant or member of a public retirement system? For an employee to be excluded from mandatory social security coverage, the employing entity must maintain a retirement system as defined by Internal Revenue Code section 3121(b)(7)(F).  The employee must also be a qualified participant in that system, as defined in Internal Revenue Code Section 3121.

An entity may maintain a retirement system in which not every employee is a qualified participant.  For both defined contribution plans and for defined benefit plans, the determination of whether an individual is a qualified participant is made as services are performed; however, there are different tests to determine participation.

An employee is a qualified participant in a defined contribution retirement system with respect to services performed on a given day if, on that day, the employee has satisfied all conditions (other than vesting) for receiving an allocation to his or her account (exclusive of earnings) that meet the minimum retirement benefit requirement.  The benefit must be calculated with respect to compensation during a period ending on that day and beginning on or after the beginning of the plan year of the retirement system.  This is the case regardless of whether the allocations were made or accrued before the effective date of Internal Revenue code section 3121.

Here is an example:  A political subdivision maintains an elective defined contribution plan as defined by IRS regulations.  The plan operates on a calendar year.  It has two open seasons – in December and June – when employees can change their contribution elections.  In December, an employee elects not to contribute to the plan.  In June, the employee elects (beginning July 1) to contribute a uniform percentage of compensation for each pay period to the plan for the remainder of the plan year.

The employee is not a qualified participant in the plan during the period January-June because no allocations are made to the employee's account during that time.  If the level of contributions during the period of July-December meets the minimum retirement benefit requirement with respect to compensation during that period the employee is treated as a qualified participant during July-December only.

An employee is a qualified participant in a defined benefit retirement system with respect to services performed on a given day if:

  1. on that day, the employee is (or ever has been) an actual participant in the retirement system and
  2. on that day, the employee actually has a total accrued benefit that meets the minimum retirement benefit requirement. 

An employee may not be treated as an actual participant under certain conditions (other than vesting) that have not been satisfied.  The conditions might include a requirement that the participant attain a minimum age, perform a minimum period of service, make an election in order to participate, or be present at the end of the plan year in order to be credited with an accrual.

An example would be a political subdivision that maintains a defined benefit plan that is a retirement system under IRS regulations.  Under the terms of the plan, service during a plan year is not credited for accrual purposes unless a participant has at least 1,000 hours of service during the year.  For purposes of determining whether social security coverage applies, benefits that accrue only upon satisfaction of this 1000 hours requirement may not be taken into account in determining whether an employee is a qualified participant in the plan before the 1000 hour requirement is satisfied. 

Special rules apply to part-time, seasonal and temporary employees for purposes of determining whether they are qualified participants in a public retirement system.  To be exempt from mandatory social security coverage, these employees must not only be qualified participants; but they must be fully vested in their benefits.  This means the benefits cannot be forfeited.  If a part-time, seasonal or temporary employee is not a qualified participant in a public retirement system with benefits fully vested from the first day of employment, that employee is subject to mandatory social security and Medicare tax until the employee becomes fully vested.

The special vesting requirement is considered to be met if a part-time, seasonal or temporary employee in a defined benefit plan has the right to at least 7.5 percent of the compensation the employee earned while covered under the retirement system plus interest when the employee leaves employment. 

For purposes of applying the qualified participant test, part time employees are those who normally work 20 hours or less per week.  If mandatory coverage applies, part time positions cannot be excluded; but part time positions may be excluded from coverage under a Section 218 Agreement, at the option of the State.

A special rule provided that  teachers employed by a post-secondary educational institution such as a community or junior college, post secondary vocational school, college, university or graduate schools are not considered part-time if the teacher normally teaches half or more of the number of classroom hours normally considered to be full-time employment.

For example: A community college treats a teacher as a full-time employee if the teacher is assigned to work 15 classroom hours per week.  A new teacher is assigned to work eight classroom hours per week.  Because the assigned classroom hours of the new teacher are at least one-half of the school's definition of full-time teacher, the teacher is not a part-time employee for our discussion today.

For purposes of applying the qualified participant test, a seasonal employee is any employee who normally works on a full-time basis less than 5 months in a year.  For example, individuals who are hired by a political subdivision during the tax return season in order to process incoming returns and work full-time over a three-month period are seasonal employees.

For purposes of applying the qualified participant test, a temporary employee is one who performs services under a contractual agreement that is expected to last two years or less.  Under this rule, a teacher under an annual contract may or may not be a temporary employee.  Possible contract extensions must be considered in determining the duration of a contractual arrangement if there is a significant likelihood that the employee's contract will be extended. 

Contract extensions are considered likely to occur if, on average, 80 percent of similarly situated employees have had bona fide offers to renew their contracts in the immediately preceding two academic or calendar years. Contract extensions are also considered significantly likely to occur if the employee has a history of contract extensions in the current position. These special rules are covered in Regulation 31.3121(b)(7)-2(e)(2)(iii)(C).

We have covered part-time, seasonal, and temporary employees as it pertains to this qualified participant test.  But what about an individual who works in more than one position?

If an employee is not covered by a Section 218 Agreement, but is a member of a retirement system with respect to one full-time position, the employee is generally treated as a member of a retirement system with respect to any other position with the same employer. 

Let's look at an example. An individual is employed full-time by a county and is a qualified participant in its retirement plan.  In addition to this full-time employment, the individual is employed part-time in another position with the same county. The part-time position is not covered by the county retirement plan.  Nevertheless, if the individual is a qualified participant in the retirement plan because of the full-time position, the part-time position is excluded from mandatory coverage. 

This rule does not apply to employment by two different employers.  For example, an individual is employed full-time by a state and is a member of its retirement plan, and is also employed part-time by a city located in the state, but does not participate in the city's retirement system.  The services of the individual for the city are not excluded from mandatory social security coverage, because the determination of whether services constitute employment for such purposes is made separately with respect to each political subdivision for which services are performed. These rules can be found in Regulation 31.3121(b)(7)-2(c)(2)

We have discussed a lot of information and have thrown out a lot of law and scenarios at you.  Let's take a step back and ask some questions that may help you as you review your retirement plans and determine whether your plan exempts employees from participation in social security.

  • Do you have a defined contribution plan or a defined benefit plan?
  • If you have a defined contribution plan, is the total contribution by the employer and employee at least equal to 7.5% of compensation to the retirement plan?
  • If you have a defined benefit plan do you understand that:
    • The benefit must be at least equal to or greater than 1.5% of average compensation for each year of credited service
    • The system or plan provides a single life annuity, or equivalent, payable at age 65.
    • The average compensation perimeters when the system calculates based on a period of 36 months?
    • The average compensation perimeters when the system calculates based on a period of more than 36 months (for example the highest factor over 120 months is 2.00 percent)?
    • That for any defined benefit plan the definition of compensation must generally meet the definition of the employee's base salary as designated by the employer and the retirement system, provided such designation is reasonable under all the facts and circumstances
    • If your employee is Qualified participant per Regulation 31.3121(b)(7)-2(d)(1)?

As we review what we have covered we will answer some frequently asked questions.

What is a "public retirement system" as defined by the IRS?  A "public retirement system (sometimes referred as a "FICA replacement system or plan) is a pension plan maintained by a public employer that meets the requirements of Internal Revenue Code 3121(b)(7)(F).  These requirements must be met as an alternative to mandatory social security coverage. A retirement system may be a pension, annuity, retirement or similar fund or system established by a state or political subdivision. 

The system does not have to be a state creation, nor does it have to be a plan under which the benefits are guaranteed by the state constitution.  A retirement system can include a group annuity purchased by the state or political subdivision from a private insurance company.  Whether a system qualifies as a "public retirement system" does not depend on whether it meets the requirements within the Employees' Retirement Income Security Act of 1974 or commonly referred to as ERISA.

What does it mean to be a qualified participant in a retirement system? To be a qualified participant, a member must actually participate in the system.  An employee who is eligible for an optional system, but decides not to participate, will be subject to mandatory social security tax.

How are part-time, seasonal and temporary workers defined for purposes of determining whether they are qualified participants in a public retirement system under Internal Revenue Code section 3121? A part-time employee normally works 20 hours or less per week.  A seasonal employee may work full-time, but for less than five months a year.  In the case of teachers above the high school level, part-time is defined as less than one-half the classroom hours designated as full-time by the school. 

A temporary employee performs services under a contractual agreement arrangement of two or less years.  Remember this does not apply when future contract extensions on an average of 80 percent of similarly situated employees have had bona fide offers to renew their contracts in the immediately preceding two academic or calendar years, or the contract history of a particular employee indicates that the employee is not a temporary employee.

For new employees, entering a retirement system, is there any waiting period for coverage in which social security does not have to be paid? If a full-time employee can be enrolled in the plan by the first day of the first full calendar month of service, social security taxes do not have to be paid during the partial month in which he or she begins work.  This rule does not apply to part-time, seasonal, and temporary employees.

Is a retirement system that does not cover all employees a "retirement system" within the meaning of Regulations 31.3121? A retirement system is not required to cover all employees; it may be a retirement system for some employees and not others.  The coverage determination is made separately for each individual.

A teacher who is a participant in a retirement system during the academic year also works a few hours per week in the summer in the school library.  The library job is not covered by a Section 218 Agreement or by the public retirement system because it does not fall during the normal 10-month school year.  Are the wages for the summer job subject to social security or Medicare taxes?  Not for social security but possibly Medicare.  The wages are not subject to social security taxes because the teacher is a qualified participant in the public retirement system with respect to her full-time job.  The Medicare tax applies, unless the employee was hired prior to April 1, 1986, and qualifies for the continuing employment exception.

We have discussed Revenue Procedure 91-40 that defines rules relating to the minimum retirement benefit requirement prescribed under 31.3121(b)(7)-2 of the Employment Tax Regulations.  We have discussed the ways government employers and employees participate in social security and/or Medicare as well as when the employers and employees are exempt from social security if participating in a FICA replacement plan as qualified participants.

One other area where employees may not participate in social security is for rehired annuitants.  We will not be discussing this here.  However, this topic may be presented in the future. Please check back at the FSLG web page.

Again, this presentation is not official guidance for your specific issues.  We have provided general guidance to help government entities understand the unique nature of FICA replacement plans.  If you have a more specific question following this phone forum, you can go to IRS.gov and keyword search "FSLG Newsletter".  Within the newsletter you will see a list of FSLG Specialists for your State whom you can call and ask questions unique to your entity.  If you do not already receive the FSLG Newsletter, you can also sign up to receive the newsletter from this page.

In addition, you can email us with your request at te.ge.fslg.outreach@irs.gov

This forum will be posted on our site along with a transcript.  Use the email address to request the link once it is posted.  Please use FICA Plans in the subject line.

Again. Thank you for attending today's session.  Have a good day.