A retirement plan has lots of benefits for you, your business and your employees. Retirement plans allow you to invest now for financial security when you and your employees retire. As a bonus, you and your employees get significant tax advantages and other incentives.

Business benefits

Employer contributions are tax-deductible.
Assets in the plan grow tax-free.
Plan options are flexible.
Tax credits and other benefits for starting a plan may help reduce costs.
Retirement plans can attract and keep better employees, which reduces new employee training costs.
Employee benefits

Employee contributions can reduce current taxable income.
Contributions and investment gains are not taxed until distributed.
Contributions are easy to make through payroll deductions.
Interest accrues over time, which allows small, regular contributions to grow to significant retirement savings.
Retirement assets can be carried from one employer to another.
The saver's credit may be available to some employees.
Employees can improve financial security in retirement.
Future retirement savings value

Monthly Savings, 6% 5 Years 15 Years 20 Years $50 $3,506 $14,614 $23,218 $200 $14,024 $58,455 $92,870 $500 $35,059 $146,136 $232,176
What are the first steps to learning about and setting up a retirement plan?

A good place to start is by contacting a tax professional familiar with retirement plans or a financial institution that offers retirement plans. Helpful reading materials and IRS websites are listed at the end of this page.

What are the stages of sponsoring a retirement plan?

Sponsoring a retirement plan has four stages: Choosing, Establishing, Operating, and Terminating the plan.

Choosing

There are many different retirement plans you can choose to adopt. You select a plan by:

Considering how much money you will need in retirement, and
Learning about the types of tax-qualified retirement plans that will help you save for your and your employees’ retirement.
Establishing

You take the necessary steps to put your plan in place. Depending on the type of plan you choose, the administrative steps may include:

adopting a written plan;
arranging a trust for the plan’s assets;
notifying eligible employees about the terms of the plan; and
creating a recordkeeping system.
Operating

You want to operate your retirement plan so that the assets in the plan continue to grow and the tax-benefits of the plan are preserved. The ongoing steps you need to take to operate your plan may vary depending on the type of plan you establish. Your basic steps will include:

covering eligible employees;
making contributions;
keeping the plan up-to-date with retirement plan laws;
managing the plan assets;
providing information to employees participating in the plan; and
distributing benefits.
Terminating

When your plan no longer suits your business, you will close out the plan and notify the appropriate parties.

You may want to discuss these four stages with a tax professional familiar with retirement plans or a financial institution that offers retirement plans.

Retirement plans established for the benefit of governmental employees generally function in ways similar to those covering private employers. However, in many cases, different Sections of the Internal Revenue Code determine the tax treatment of these plans. Depending on the statutory basis for the plan and how it operates, employer and employee contributions may be subject to Federal income tax at the time of contribution, or tax-deferred until distributed; and they may be taxable or excluded from social security and Medicare taxes (FICA).

Public Retirement Systems (FICA Replacement Plans)

Effective July 2, 1991, Congress made social security coverage mandatory for state and local government employees who are neither covered by a Section 218 Agreement nor qualifying participants in a public retirement system. Under this provision, states can provide these mandatorily covered employees with membership in a public retirement system as an alternative to mandatory social security coverage. Employees may also be covered by both a public retirement system and social security under a Section 218 Agreement.

A governmental retirement plan must meet certain minimum benefit or contribution standards to qualify as a public retirement system, and thereby serve as a “replacement” plan exempting the participants from mandatory social security coverage. These standards are based solely on meeting a minimum benefit level provided (defined benefit plan), or a minimum amount contributed (defined contribution plan) to the participant. Whether a plan meets the standard to exempt employees from mandatory FICA has no bearing on the rules discussed below, and a public retirement system is not necessarily a “qualified plan” within the meaning of Employee Retirement Income Security Act (ERISA). For a detailed discussion of the requirements for public retirement systems, see Chapter 6 of Publication 963, Federal-State Reference Guide PDF.

Types of Public Employer Plans

The following types of retirement plans are discussed here (Sections refer to the Internal Revenue Code)

Section 401(a) - Qualified Plan

Section 403(b) – Annuity for public schools and 501(c)(3) organizations

Section 457(b) – Nonqualified, eligible deferred compensation plans for state and local governments and tax-exempt organizations

Section 457(f) – Nonqualified, ineligible deferred compensation plans

Note: After May 6, 1986, state and local governments are not eligible to adopt Section 401(k) plans except for rural cooperatives and Indian tribal entities. Under grandfather provisions, plans established prior to that date may continue to operate and add new participants.

Almost all governmental plans are covered under one of these Sections. They are discussed individually below.

Key Terms and Concepts

The following are some important terms that are used in discussing the features of public employer plans.

Constructive Receipt: Under the provisions of Sections 451 and 457 of the Internal Revenue Code, generally all amounts employees receive are taxable when received or made available to the employee. However, numerous code Sections provide exceptions to either defer or exempt amounts from current employee income. They are discussed below as they apply to governmental plans.

Employer Contributions: Amounts credited to individual employee retirement accounts paid in addition to salary; the employee does not have the option to receive these amounts in cash. These amounts are always tax deferred, because the employee does not have constructive receipt. Except for Section 457(b) deferrals and Section 457(f) contributions, employer contributions are exempt from FICA.

Tax-Deferred: Refers to amounts set aside or credited to the employee retirement account and not included in gross income at the time of the transaction. They are included in income when they are distributed to or constructively received by the employee. Generally, they are subject to withholding requirements at that time also.

Salary Reduction Agreement: An arrangement that provides for amounts recognized as a cash or deferred election because the employee either (a) elects to reduce cash compensation, or (b) elects to forego an increase in cash compensation.

Mandatory Employee Contributions: Amounts deducted from employee salary and credited to a retirement account.

Employer “Pick-Up” Contributions: Section 414(h)(2) allows state or local government entities with Section 401(a) plans to treat certain contributions designated as employee contributions, but which are “picked up” (paid) by the employer, to be treated as employer contributions, and therefore as exempt from income tax. This does not include contributions made under a salary reduction agreement. For purposes of FICA, the term “salary reduction” relates to amounts treated as an employer contribution under Code §414(h)(2) that would have been included in wages for FICA tax purposes, but for the employer contribution.

Section 401(a) Qualified Plans

Generally, any public employer may set up a 401(a) plan. Under this plan:

Employer contributions not made pursuant to a salary reduction agreement, but including employer “pick-up” contributions, are deferred from income tax until distribution, and exempt from social security and Medicare tax.

Employer contributions made under a salary reduction agreement are deferred from income tax, but are subject to FICA tax.

Employee contributions pursuant to a salary reduction agreement are subject to income tax and FICA tax.

Section 403(b) Plans

Plans under IRC Section 403(b), also called tax-sheltered annuities, are available to certain employees of public schools, employees of certain tax-exempt organizations, and certain ministers. To maintain a Section 403(b) plan, a governmental employer must be a public school of a state, political subdivision of a state, or an agency or instrumentality of one or more of these. Many public school employees are covered by 403(b) plans in addition to social security coverage under Section 218.

403(b) plans resemble “qualified” (i.e., 401(k)) plans in many respects. Eligible participants may defer amounts from income tax up to an annual limit ($19,500 in 2020 and 2021). This amount may be increased for certain employees with more than 15 years of service. In addition, additional tax-deferred “catch-up” contributions may be made to employees age 50 or older.

Employer contributions (within dollar limitations) are tax-deferred and exempt from FICA.

Employee elective contributions to 403(b) plans that are considered employer contributions pursuant to a salary reduction agreement are deferred from income tax, but taxable for FICA.

For more information on catch-up contributions to 403(b) plans, see Publication 571 .

Section 457(b) Plans

Section 457 addresses nonqualified plans. Many public employees participate in nonqualified, or Section 457, plans. These plans can be established by state and local governments or tax-exempt organizations. If they meet the requirements of IRC Section 457(b), they are considered “eligible” plans; if not they are considered “ineligible” and are governed by IRC Section 457(f).

Governmental 457(b) plans must be funded, with assets held in trust for the benefit of employees. Plan assets and income of all other eligible plans must remain the property of the employer.