The ABCs and 123s of 3121 Plans
As the compliance attorney for Keenan’s financial services products, I’m often asked to explain complicated state and federal laws. As a child of the ‘70s, I am a huge fan of the Jackson 5’s greatest hits. Lately, I’ve been asked to clear up some misconceptions about 3121 plans, like Keenan’s APPLE. You may or may not wish to hum along, as I talk about a lot of ABCs and 123s, or in this case SSAs, 3121s and 218s…
“FICA” stands for the “Federal Insurance Contributions Act.” It is the law that funds Social Security and Medicare by requiring employers and employees to pay a tax out of payroll. The tax is typically 7.65% of earnings up to a limit set by law and indexed for inflation ($127,200 in 2017.)
Section 3121 of the tax code provides that the wages subject to FICA include all compensation for “employment.” “Employment” includes any service performed by an employee for an employer within the United States, but is subject to a number of exceptions. Employment for FICA purposes does not generally include service performed as an employee of a State, any political subdivision of a state (like a municipality) or any instrumentality of either of the state or a subdivision of the state (like an agency, university or school district.) However, this being the tax code, there are exceptions to this exception. For our purposes, the important ones are (1) for service included under a Section 218 Agreement, and (2) for service by an individual who is not a member of a public retirement system.
A Section 218 Agreement is a voluntary agreement between the State and the Social Security Administration (SSA) to provide Social Security and Medicare (or sometimes just Medicare) for State and local government employees. (These are called “Section 218” Agreements because they are authorized by Section 218 of the Social Security Act.) Section 218 Agreements cover specified state and local government positions. If the position is covered for Social Security and Medicare under a Section 218 Agreement, then any employee filling that position is subject to FICA. Essentially, employees covered under a Section 218 Agreement pay into the Social Security system and have the same coverage and benefit rights as employees in the private sector.
Certain employee services are excluded from Social Security coverage under a Section 218 Agreement. Some of those exclusions are mandatory, and others are optional—that is, states may exclude them, but do not have to. California’s 218 Agreement with the SSA generally excludes from coverage all state and local employees whose current service is covered by CalPERS or CalSTRS.
Of course, the State of California and local governments also employ people whose service is not covered by CalPERS or CalSTRS. Generally those employees would pay FICA, unless the public employer establishes a “retirement system” for them. Section 218(b)(4) of the Social Security Act defines a “retirement system” as a pension, annuity, retirement, or similar fund or system established by a State or by a political subdivision. Therefore, those state and local employees who are not covered under PERS or STRS are subject to FICA for that employment unless their employer offers an alternative retirement plan.
FICA ALTERNATIVE PLANS
A 3121 plan or “FICA alternative plan” is a plan that provides retirement benefits, and has an accrued benefit or receives an allocation under the system that is comparable to the benefits the employee would have or receive under Social Security. For part-time, seasonal or temporary employees, the benefit must be 100% nonforfeitable. A FICA alternative plan can be either a defined benefit or a defined contribution plan. It can be written under sections 403(b), 457 or 401(a) of the Internal Revenue Code.
There are advantages to establishing a FICA alternative plan like Keenan’s APPLE for an agency’s part-time, seasonal and temporary employees that aren’t covered under CalPERS or CalSTRS. A FICA alternative plan can be less expensive than payroll taxes under FICA. It can provide budget savings for employers and increase the employees’ take-home pay, while still providing pretax retirement benefits for the employees covered under the plan. The employee receives an increase in take-home pay and benefits from a pretax retirement plan. The employer eliminates FICA contributions for those employees. However, during the time of the employee’s covered service, no contributions will be made to Social Security and no Social Security credits will be earned for the employee’s work.
You may hear a 3121 plan being referred to as a “replacement for” for Social Security. That description is not entirely accurate. While the plan is designed to provide a benefit comparable to Social Security, it may not actually replace Social Security for some employees. A participant in a 3121 plan may still qualify for Social Security through work performed either before or after the time he or she participates in the plan. Eligibility for and the amount of benefits a person receives under Social Security depends on the number of credits earned by the worker. In 2017, a person earns one credit for every $1,300 of FICA-covered income, up to a maximum of four credits a year. How many credits an employee needs to qualify for Social Security depends on the person’s age and type of benefit, but no one needs more than 40 credits to qualify for any benefit. Therefore, participation in a 3121 plan does not necessarily mean that the participant will forgo receiving Social Security benefits, but can affect the eligibility and amount of those benefits.