What Is the Difference Between 414hnot and 414hsub?

Employee contributions to governmental retirement plans receive specific tax treatment under Internal Revenue Code (IRC) Section 414(h). This section allows for certain employee contributions to be reclassified as employer contributions for tax purposes, which can impact an individual’s current tax liability and future retirement distributions. Understanding Section 414(h) is important for public sector employees’ retirement and tax planning. The Internal Revenue Code outlines two primary ways these contributions are handled, each with distinct tax implications.

Overview of Section 414(h)

Section 414(h) provides rules for employee contributions to governmental retirement plans (state, local, or federal). This section permits governmental employers to “pick up” employee contributions. “Pick up” means that the employer formally designates these employee contributions as employer contributions for tax purposes, even though the funds originate from the employee’s salary. This reclassification is significant because employer contributions often receive different tax treatment than employee contributions.

For a contribution to be considered “picked up” by the employer, the Internal Revenue Service (IRS) requires certain conditions to be met. The employer must specify that they are directly paying the employee contributions into the plan. Additionally, the participating employee must not be allowed to choose to receive the contributed amounts directly instead of having them paid to the retirement plan. This mechanism allows for tax advantages that might not otherwise be available for employee contributions to retirement plans.

The 414(h)(1) “Not” Contribution

Under Section 414(h)(1), employers “pick up” contributions and treat them as employer contributions for federal income tax. These contributions are not included in the employee’s gross income for federal income tax withholding in the year they are made. This means the employee’s current taxable income is reduced by the amount of these contributions, leading to a lower immediate federal income tax liability. The employee does not claim these contributions as a deduction on their tax return because they are already excluded from their taxable wages reported on Form W-2.

While these contributions are excluded from federal income tax in the year they are made, they are still subject to Social Security and Medicare (FICA) taxes. FICA taxes are withheld from these contributions. The federal income tax on these contributions is deferred until the employee receives distributions from the plan in retirement. When distributions occur after age 59½, they are subject to ordinary income tax rates.

The 414(h)(2) “Sub” Contribution

Contributions under Section 414(h)(2) are also “picked up” by the employer and treated as employer contributions. However, unlike 414(h)(1) contributions, these amounts are “subject” to federal income tax in the year they are made. This means they are included in the employee’s gross income for federal income tax withholding. Despite being subject to income tax upfront, 414(h)(2) contributions are not subject to Social Security and Medicare (FICA) taxes.

This exemption from FICA taxes can provide a direct payroll tax saving for the employee in the year of contribution. Because income tax is paid on these contributions upfront, qualified distributions from them in retirement are tax-free. This provides a different tax benefit profile, shifting the tax burden from future distributions to the present.

Comparing the Tax Implications

The two types of 414(h) contributions present distinct tax implications for governmental employees. For federal income tax, 414(h)(1) contributions offer tax deferral, meaning the income tax is paid later during retirement distributions. Conversely, 414(h)(2) contributions are subject to federal income tax in the year they are made. This difference dictates whether an employee’s current taxable income is reduced or not.

Regarding FICA taxes, the treatment also varies significantly. Contributions under 414(h)(1) are subject to Social Security and Medicare taxes. In contrast, 414(h)(2) contributions are exempt from FICA taxes.

This FICA exemption for 414(h)(2) contributions can result in immediate payroll tax savings for the employee, influencing their take-home pay. With 414(h)(1), the reduction in current federal income tax withholding may lead to a slightly higher net pay initially, despite FICA taxes still being applied. For 414(h)(2), while federal income tax is paid upfront, the absence of FICA taxes can also result in a favorable impact on current take-home pay.

The long-term tax treatment of distributions also varies; 414(h)(1) distributions are taxed in retirement, while 414(h)(2) contributions are tax-free upon withdrawal since income tax was already paid. Both 414(h)(1) and 414(h)(2) contributions count towards the overall contribution limits for qualified retirement plans under Section 415 of the Internal Revenue Code. These distinctions are important for financial planning. The choice between these two types of contributions, or the structure of a plan offering them, influences an individual’s current tax liability versus their future tax liability, requiring consideration of their overall financial strategy.