Little-known tax law lets public, nonprofit workers save more

If you work for a company that offers a 401(k) plan, the most you can contribute before taxes this year is $13,000 or, if you’re older than 50, $16,000.

But if you work at a state or local government, educational or not-for- profit institution that offers two types of defined-contribution plans, you can contribute twice that much, thanks to a tax law change that has gotten little attention outside the public sector.

Kathleen Pender

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Full-time employees of the state of California, the California State University system, and some California cities and counties can contribute a total of $26,000 per year to two plans, or $32,000 if they’re older than 50. University of California employees will have the same opportunity before year- end.

The Economic Growth and Tax Relief Act of 2001 abolished a rule that reduced the amount employees could contribute to one plan by the amount they were contributing to another plan. The new law, which took effect in 2002, essentially doubled the amount certain employees in the public and not-for- profit sectors could sock away.

It’s a sweet deal for teachers and other public-sector employees if they can afford it.

"Congress intended to liberalize the rules for public plans as many public employers do not offer Social Security, and generally speaking, public pay scales are lower than in the private sector," says Trey Davis, a spokesman for the University of California.

That may be true. But unlike a growing number of private-sector workers, most government employees are covered by generous defined-benefit plans — which guarantee a certain monthly pension in retirement — in addition to one or two defined-contribution plans.

Almost all state-government employees in California, including those at the universities, are covered by Social Security as well.

How it works

There are three basic types of defined-contribution plans, which let employees invest a certain amount of their income before it is taxed. The money grows tax free. When it is taken out, it is taxed as ordinary income. All three typically let employees choose from a range of investment options such as mutual funds and annuities.

— 401(k) plans: Private-sector employers (for-profit and not-for-profit) can offer the 401(k) plan. (Government employers generally cannot offer 401(k) plans unless they were established before May 1986.)

— 403(b) plans: Public schools and colleges, churches, public hospitals and tax-exempt charitable organizations can offer employees a 403(b).

— 457 plans: Most state and local governments and some tax-exempt organizations can offer these.

Nonprofits, however, generally can offer 457 plans only to highly compensated employees because of complex retirement-security laws, says Lee Trucker of Trucker Huss, an employee-benefits law firm.

State and local governments and not-for-profits can offer a 457 plan in addition to a 403(b) or 401(k) plan. Before 2002, however, there was not much reason to sponsor both.

That’s because the most employees could put into two plans combined was the maximum allowed by the plan with the lower limit.

For example, in 2001, employees could contribute $10,500 to a 403(b) plan or 401(k) plan — but only $8,500 to a 457 plan.

Employees contributing to a 457 plan who were also contributing to one of the others could put in only $8,500 combined.

The 2001 tax act established higher, uniform limits for all three types of plans. (This year, the limit is $13,000, plus an additional $3,000 catch-up contribution for people who will be 50 or older by year-end.)

More importantly, it said employees participating in a 457 and another plan could contribute the maximum allowed by each plan.

Who benefits?

The new law was an immediate bonus for employers like the state of California, which was already operating a 401(k) and a 457(b) plan for full- time employees of the state and the California State University system. The two plans operate under the Savings Plus Program banner.

It has also led to "a huge explosion of 457 plans for nonprofits and school districts," says Brion Beetz, regional vice president with Great-West Retirement Services in San Ramon.

The 2001 tax act eliminated the big drawbacks of 457 plans, such as the lower contribution limits and the inability to move the accounts when employees change jobs.

But it did not eliminate their big advantages: There is no tax penalty for withdrawing money from a 457 plan before age 59 1/2 as there usually is with 403(b) and 401(k) plans.

Also, if employees have not contributed the maximum amount to a 457 plan every year, three years before their normal retirement age, they can double up on their regular contribution.

Before the tax act, the 457 plan "was the stepchild of the defined- contribution business. Now it is the kingpin of the defined-contribution business," says Beetz.

He attributes the new law to "a huge lobbying effort" by state and local government.

Early this year, the University of California decided to offer a 457 for its full-time employees, in addition to its existing 403(b) plan.

This month, the university hired Fidelity Investments to administer the new plan. Eventually, Fidelity will take over the administration of the 403(b) plan and a third defined-contribution plan for part-time workers. The university is also looking to provide a new range of investment options in all of its plans and to provide a single consolidated statement.

The UC system wants to open the plan before year-end because it has a lot of employees nearing retirement age who would like to beef up their savings.

Last year, about 12,000 UC faculty and staff at all income levels contributed the maximum to their 403(b) plans, says Gary Schlimgen, UC’s director of policy and program design. That’s about one-fourth of all plan participants.

"We have had questions from employees making $50,000 to $60,000 year. They max out on the 403(b) and want to do more on the new plan," says Schlimgen. Often, these employees have funds to invest from a spouse or domestic partner who has a job but no retirement plan at work.

The state doesn’t know how many employees are maxing out on their 401(k) and 457 plans. Three years ago, before the new law took effect, about 20,000 employees were making the maximum contribution, which at the time was $8,500 or $10,500.

Only 40 percent of state employees who are eligible to contribute to the defined-contribution plans do so, perhaps because "we have a very rich defined- benefit plan," says Lura Franzella, administrator of the state’s Savings Plus Program. Also, the state does not make any contribution to employees’ defined- contribution plans, as some private-sector employers do.

Other employers that offer a 403(b) plan plus a 457 include the University of Southern California, the California Institute of Technology, the city of Concord, the Santa Cruz County Office of Education, the San Luis Obispo County Office of Education, the University of Illinois and Michigan State University.

Net Worth runs Tuesdays, Thursdays and Sundays. E-mail Kathleen Pender at [email protected].