Could a special pay plan contribution be right for your school district?

Help your employees maximize the value of their retirement savings with special pay plans

Each June, after the close of the school year, educators typically announce their retirement. And, if the educator who is about to retire has been a long-term employee, it is likely the individual will have a significant balance of unused accumulated sick and/or vacation pay at the time of retirement. 

A popular way to handle such unused accumulated leave is for a school district to make an employer contribution of the unused leave amount into the retiring educator’s 403(b) plan. This “special pay” plan feature has the advantage of enabling a 403(b) plan participant to withdraw those employer contributions when needed (subject to required minimum distribution rules) rather than receiving the unused leave as compensation (which would be subject both to income tax and, if applicable, FICA taxes) in the last year of employment.

What you need to know when considering a 403(b) plan special pay feature

As any educator will tell you, doing your homework is essential — and that applies to a school district that either has, or is contemplating, a special pay feature as part of the 403(b) plan:   

1. The employer contribution of unused accumulated leave must be non-elective. 

A 403(b) plan is the only type of retirement plan that permits an employer to make contributions to a former employee for up to five years after that individual has terminated employment. But these employer contributions must be non-elective contributions to its 403(b) plan in order to satisfy Internal Revenue Service (IRS) criteria. 

If a retiring employee has the right, directly or indirectly, to receive unused accumulated leave as compensation instead of the employer remitting that contribution to the 403(b) plan, the IRS will not consider the employer contribution to be non-elective. 

A special pay contribution might not meet the employer non-elective contribution requirement if:   

• An employee eligible for this special pay employer contribution can opt out of having that contribution allocated to his account under the 403(b) plan; or
• The 403(b) plan provides for an employer special pay contribution only if a participant’s leave balance is above a stated hour or dollar threshold.  

2. The 403(b) plan document must define the participants eligible to be allocated this employer special pay contribution.

The 403(b) plan document must define the employees eligible for this employer non-elective contribution. That definition of eligible employees should be reasonable and uniformly applied.

When defining eligible employees for this special pay contribution, review:

• State law. Will an employer non-elective contribution of accumulated leave impact the retiring employee’s benefit under the teachers’ retirement system?  Does the state law require that unused accumulated sick and/or vacation leave be paid directly to the retiring employee in lieu of an employer non-elective contribution to the 403(b) plan? 
• Collective bargaining agreements.  If a collective bargaining agreement  requires that unused accumulated leave in whole or in part must be paid to the terminating employee, the collective bargaining agreement would need to be amended to permit an employer special pay contribution. 

3. Remember that special pay contributions are subject to IRS contribution limits.

In general, the total of employer and employee contributions that can be contributed to a participant’s account under a 403(b) plan cannot be more than 100% of compensation up to $69,000 in 2024 (and subject to IRS annual cost of living adjustments):

• In the year that the employee retires: Employer contribution that can be made to the 403(b) account must be reduced by employee contributions (other than any age 50+ catch-up) that the retiring employee contributes in that year.
• In the five years after the year of termination: Since the individual is retired, the employer special pay contribution will be taken into account for the IRS contribution limit. For these purposes, a former employee’s compensation is deemed paid monthly and is equal to one-twelfth of that individual’s compensation during the most recent year of service with the school district.

If the former employee dies during this five-year period, the IRS requires that the employer special pay contribution in the year of death be prorated, a fraction where the numerator is the number of months that that individual lived in that year over a denominator of 12. No further contributions can be made to the former employee’s 403(b) account following the year of death.

Some additional steps for school districts with a special pay contribution

• Review contracts to ensure employer 403(b) contributions are permissible.
• Ensure active and retiring employees are not provided with any choice/option — in any documents or in actual operation — to receive unused accumulated leave in cash.
• Be sure to check any employee communications, collective bargaining agreements, plan documents and any other relevant documents.
• Review the IRS 403(b) regulations carefully to ensure that any employer non-elective contributions to be made after the death of the former employee are consistent with the limitations of those regulations.
• Present to Board a resolution to adopt a special pay plan.
• Update your plan document to permit special pay contributions in accordance with the criteria that your school has established.
• Communicate with employees who will be affected by your school’s special pay plan to ensure that they understand IRS rules regarding when contributions may be made to the plan.

If you have questions or would like assistance, reach out to your Voya Relationship Manager.