What Is a Pickup Contribution for Tax Purposes?

A pickup contribution is a feature in certain governmental retirement plans that re-characterizes mandatory employee contributions as employer contributions for federal income tax purposes. This allows an employee to defer paying income tax on the contributed amount until retirement. While the funds originate from the employee’s total compensation, this accounting treatment provides an immediate tax benefit. The arrangement is an embedded characteristic of how a specific government pension plan is structured.

The Pickup Contribution Mechanism

Under Internal Revenue Code Section 414, a state or local government can “pick up” contributions that are otherwise required from its employees. This process is an accounting re-characterization rather than a literal payment by the employer on top of salary. The employee’s gross compensation is not altered, but the picked-up amount is subtracted from the total pay before calculating taxable income for federal purposes.

This is a paper transaction where funds are sourced from the employee’s established salary. For example, a public school teacher may have a contract for $65,000 annually with a mandatory 7% pension contribution. The school district, through a formal action, can designate that $4,550 contribution as “picked up.” While the teacher’s total compensation is still valued at $65,000 for calculating retirement benefits, their federally taxable income for that year is reduced by $4,550.

This arrangement is non-elective for the individual employee. An employee covered by a plan with a pickup provision cannot choose to receive the contributed amount as cash or opt out of the pickup treatment. It is an automatic feature of the employment and the associated retirement plan. The employer’s decision to implement this structure applies to all employees within the specified group.

Tax Treatment of Pickup Contributions

The primary benefit of a pickup contribution is the deferral of federal income tax. The amounts designated as picked up by the employer are excluded from the employee’s gross income for the year the contribution is made. This results in a lower taxable income reported on Form W-2 and less federal income tax being withheld from each paycheck. This tax deferral often applies to state income taxes, depending on state law conformity.

These contributions are still subject to Federal Insurance Contributions Act (FICA) taxes. This means that while the picked-up amount is not counted for income tax, it is included when calculating the employee’s liability for Social Security and Medicare taxes. On Form W-2, the picked-up amount would not be in Box 1 (Wages, tips, other compensation), but it would be included in the totals for Box 3 and Box 5.

The tax liability for these contributions is postponed until retirement. When the employee separates from service and begins to receive distributions from the pension plan, the money is then taxed. Both the original picked-up contributions and any investment earnings are treated as ordinary income in the year they are received, as no income tax has yet been paid on them.

Eligibility and Plan Requirements

Pickup contribution arrangements are exclusively available to employees of governmental entities. As defined by the IRS, this includes states, political subdivisions of a state like counties and cities, and any agency or instrumentality of a governmental unit. Public school districts, municipal police and fire departments, and state administrative agencies are common examples. Private-sector companies are not permitted to offer this type of plan feature.

The contributions being picked up must be mandatory for the employee as a condition of their public employment. The pickup provision cannot be applied to any voluntary or elective contributions an employee might choose to make to a supplemental retirement account, such as a 403(b) or 457(b) plan.

The employer must take formal, official action to specify that it is picking up the employee contributions. This is typically accomplished through a documented ordinance, resolution, or another formal act by the governing body of the governmental unit. There must be a clear, preceding legislative action establishing the pickup.

The plan’s structure must not give the employee the option to receive the contributed amounts as cash instead of having them paid to the pension plan. If an employee has a choice between the contribution or cash, the amount is considered an elective deferral and does not qualify for the special tax treatment. The lack of an employee choice is a defining feature of a compliant pickup plan.