Key takeaways
- A 414(h) plan is a tax-advantaged retirement savings account that is offered to many government employees.
- These plans allow for tax-deferred growth and don’t have income caps, and because contributions aren’t counted as income, employees can avoid payroll taxes.
- However, they come with less flexibility for contributions and are not eligible for the Saver’s Tax Credit.
Many government employees are eligible for a special type of retirement plan known as a 414(h) plan. These plans offer tax-deferred contributions and the potential for lower taxable income. Here’s what you need to know about 414(h) plans and how they work.
What is a 414(h) plan?
A 414(h) plan, also known as a pick-up plan, is an employer-sponsored retirement account available to public employees who work for the federal, state or local government.
Employees and employers can contribute to a 414(h) plan, with employees contributing a fixed dollar amount or a percentage of their income, as established by the employer. Employee contributions are then “picked up” by the employer, excluding them from the employee’s gross income for the year. Because the contribution is not counted as income, employees are able to avoid payroll taxes of 7.65 percent for Social Security and Medicare. This tax advantage is a key difference from 401(k) plans.
Contributions to a 414(h) plan can grow tax-deferred until withdrawn in retirement, defined as after age 59 ½. Withdrawals are then taxed as income at ordinary income tax rates.
Employee contributions are automatically fully vested, meaning that employees can take all the money in the account, should they decide to leave. A 414(h) plan also doesn’t have any income restrictions, meaning that any qualified employee can participate regardless of their income, unlike IRAs.
To comply with IRS regulations, employers must state that they will directly contribute the worker’s funds to the plan. In addition, workers cannot choose to receive the funds instead of the retirement contribution or opt out of the “pick-up.”
When can you withdraw money from a 414(h) plan?
Once the employee reaches the age of 59 ½ years old, they can withdraw money from the plan without incurring a penalty. Required minimum distributions (RMDs) also begin once the account holder reaches 73 years old. Account holders can withdraw funds before 59 ½, but they’ll be subject to income taxes, plus a penalty of 10 percent.
However, they can withdraw money without a penalty for select reasons, such as unreimbursed medical expenses exceeding 10 percent of their adjusted gross income, if they’re military reservists called to active duty or if they separate from a government or public service position after age 55 (or 50 for certain professions). The IRS has a comprehensive list of qualifying circumstances.
Advantages of 414(h) plans
414(h) plans have a number of advantages:
- No income cap: Unlike some retirement plans, a 414(h) doesn’t have any income restrictions that prohibit employees from participating if they earn too much.
- Pre-tax contributions: Employees’ taxable income is reduced as the money is directly taken from a paycheck pre-tax, reducing not only income taxes but also payroll taxes for Social Security and Medicare.
- Tax-deferred growth: Money in a 414(h) retirement account grows without immediate tax obligations. Funds aren’t taxed until they are withdrawn from the account.
- Contributions are automatically vested: In a 414(h) plan, contributions are automatically vested, meaning account holders don’t have to wait for the contributions — including employer contributions — to be theirs.
Disadvantages of 414(h) plans
While there are a lot of benefits to having a 414(h) plan, there are a few drawbacks:
- Penalties for early withdrawals: A 414(h) imposes substantial costs if you need to withdraw your money before retirement age. Not only will you owe income tax on the withdrawal, but you’ll also be hit with a 10 percent bonus penalty.
- Not eligible for Saver’s Credit: A 414(h) plan is not eligible for the Saver’s Tax Credit, also known as the Retirement Savings Contributions Credit. That tax credit is designed to encourage low- to moderate-income taxpayers to save for retirement.
- Less flexibility on contributions: Since employers determine the contribution amount, savers may have less flexibility and control compared to other retirement plans, such as an IRA or 401(k), where the account holder can contribute as much or as little as they wish, up to the annual limits.
Tax implications of 414(h) plans
If a 414(h) plan is set up properly, employee contributions are treated as employer contributions and excluded from gross income for the year, which means employee taxable income will be reduced. Additionally, the contributions are exempt from Social Security and Medicare tax, also known as FICA. Like many retirement accounts, the money in a 414(h) grows tax-deferred.
Withdrawals are subject to ordinary income taxes at the federal and state level and are generally subject to an early withdrawal penalty of 10 percent, too.
Comparison to other retirement plans
| Account | Types of account holders | Advantages | Disadvantages |
|---|---|---|---|
| 414(h) | Government employees | – No income cap – Pre-tax contributions, tax-deferred growth – Contributions are automatically vested – Contribution is not counted as income |
– Penalties for early withdrawals – Not eligible for Saver’s Credit – Limited investment options – RMDs at age 73 – Less flexibility on contributions |
| 401(k) | Company employees | – No income cap – Pre-tax contributions, tax-deferred growth – Eligible for Saver’s Credit |
– Penalties for early withdrawals – Limited investment options – RMDs at age 73 |
| 403(b) | Employees of certain non-profit tax-exempt organizations, including colleges, universities, schools and hospitals | – No income cap – Pre-tax contributions, tax-deferred growth – Eligible for Saver’s Credit |
– Penalties for early withdrawals – Limited investment options – RMDs at age 73 |
| 457(b) | Employees of state and local governments and some tax-exempt organizations | – No income cap – Pre-tax contributions, tax-deferred growth – Eligible for Saver’s Credit – No 10% tax penalty for withdrawing before age 59 ½ |
– Employer contributions are less common – Stricter rules for withdrawals – Limited investment options – RMDs at age 73 |
| IRA | Anyone with earned income | – No income cap – More investment options – Pre-tax contributions, tax-deferred growth |
– Penalties for early withdrawals – RMDs at age 73 – Lower contribution limits than other retirement accounts |
| Roth IRA | Anyone with earned income whose modified adjusted gross income falls below IRS limits | – More investment options – No RMDs – After-tax contributions, tax-free growth – No penalties for early withdrawals on contributions |
– Income caps – Penalties for early withdrawals on earnings – Lower contribution limits than other retirement accounts |
FAQs about 414(h) plans
Bottom line
A 414(h) plan is an employer-sponsored account for government employees that offers tax advantages and is designed to help individuals save for retirement. While the plan offers several benefits, it’s important to consider the trade-offs and tax implications before deciding whether it’s the right retirement savings plan for you. If you’re unsure about your retirement plan, consulting with a financial advisor might be a smart first step.
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