Contributions to a 414(h) plan are not tax exempt. They are tax-deferred for federal income tax purposes, which means the money leaves your paycheck before federal income tax is calculated but gets taxed in full when you draw it out in retirement. For most public employees, the same contributions are still subject to Social Security and Medicare tax in the year they are made. The distinction between exempt and deferred matters: exempt money is never taxed, deferred money is taxed later.
What “Deferred” Means on This Year’s Paycheck
Section 414(h)(2) of the Internal Revenue Code lets a state or local government “pick up” the mandatory contributions its employees make to a pension plan and treat them, legally, as employer contributions.1Office of the Law Revision Counsel. 26 U.S. Code 414 – Definitions and Special Rules The money still comes out of your gross pay. The reclassification is what produces the income tax deferral.
The pick-up isn’t automatic. The governing body — a city council, state legislature, or retirement board — has to adopt it formally by resolution or ordinance, and the plan document itself has to authorize it.2Internal Revenue Service. Employer Pick-Up Contributions to Benefit Plans Without that step, the contributions are after-tax employee money and you get no deferral at all.
When the pick-up is in place, the arithmetic is simple. If your salary is $80,000 and $6,000 goes to the plan under a 414(h) pick-up, your federal taxable wages for the year are $74,000. The $6,000 grows untaxed inside the plan. Years later, when you take distributions, every dollar you receive — your original contributions and all the investment earnings — is taxed as ordinary income at whatever bracket applies that year. Most states follow the federal treatment and exclude the contribution from state income tax too, though the specifics vary by state.
This is also different from a 401(k). A 401(k) deferral is voluntary; a 414(h) contribution is almost always mandatory. You don’t choose the amount, and you don’t opt out. The pick-up only changes how the mandatory deduction is classified for tax purposes.
Social Security and Medicare Still Apply to Most Employees
FICA taxes — 6.2% for Social Security and 1.45% for Medicare — follow their own rules.3Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates Whether your 414(h) contribution is subject to FICA depends on how the pick-up is structured.
The IRS draws a line between two versions. If the employer reduces your salary by the contribution amount, which is how nearly all 414(h) arrangements work, the contribution is treated as a salary reduction and included in your FICA wages.2Internal Revenue Service. Employer Pick-Up Contributions to Benefit Plans If the employer instead pays the contribution on top of your full salary as a genuine supplement, it can be excluded from FICA. The salary-reduction version is by far the common one, so most public employees pay Social Security and Medicare tax on the 414(h) amount.
A few situations change this. If your position is not covered by a Section 218 Agreement with the Social Security Administration and you were hired after March 31, 1986, you still owe Medicare tax but may be exempt from the Social Security portion.4Social Security Administration. Section 218 Agreements A narrower group — employees hired by the same state or local government before April 1, 1986 who have worked there continuously, belong to a public retirement system, and are not covered by a Section 218 Agreement — remains exempt from both Social Security and Medicare taxes on all wages. Any break in service with that employer ends the exemption permanently.5Internal Revenue Service. Medicare Continuing Employment Exception
Because the contribution is in your Medicare wages for most employees, it also counts toward the 0.9% Additional Medicare Tax that applies once Medicare wages pass $200,000 for a single filer or $250,000 for a joint filer.6Internal Revenue Service. Topic No. 560, Additional Medicare Tax Your employer only withholds this surtax once wages from that one job cross $200,000, so a second income source can leave a balance owed at filing.
How to Check It on Your W-2
Your W-2 shows the deferral directly. Box 1, “Wages, Tips, Other Compensation,” reports your gross pay minus the 414(h) contribution. On $70,000 in salary with a $5,000 contribution, Box 1 reads $65,000, and that smaller figure is what feeds your federal income tax calculation.
Box 3, “Social Security Wages,” and Box 5, “Medicare Wages and Tips,” behave differently. If your contribution is subject to FICA — again, the usual case — both boxes show the full $70,000. Box 3 is capped at the annual Social Security wage base ($184,500 for 2026), while Box 5 has no cap.7Social Security Administration. Contribution and Benefit Base
A gap between Box 1 and the FICA wage boxes is your sign that the pick-up is working as intended. Unlike a 401(k) deferral, which gets its own entry in Box 12 under Code D, a 414(h) contribution has no dedicated W-2 box. Some employers list the amount in Box 14, “Other”; many leave it blank. If yours is blank, you can back into the figure by subtracting Box 1 from your known gross salary and adjusting for other pre-tax items like health insurance.
What Happens When the Money Comes Out
Because the contributions went in pre-tax, every dollar coming out is ordinary income — your contributions and the earnings alike. No capital gains rate applies, and there is no partial exclusion. The distribution hits your return the same way wages would.
Take a distribution before age 59½ and a 10% additional tax usually applies on top of the regular income tax.8Internal Revenue Service. Substantially Equal Periodic Payments Several exceptions can spare you the penalty:
- If you separate from the government job during or after the year you turn 55, distributions from that employer’s plan are penalty-free.9Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
- Firefighters, law enforcement officers, corrections officers, and certain other state or local public safety workers can take penalty-free distributions beginning at age 50 rather than 55.
- A series of substantially equal periodic payments based on life expectancy, taken at least annually, avoids the penalty at any age.
- Distributions due to total and permanent disability, or paid to a beneficiary after the participant’s death, are exempt.
Those age-50 and age-55 exceptions apply only to the plan held by the employer you left. Roll the balance into an IRA first and you lose them, because IRA early-withdrawal rules are stricter on this point.
The money can’t sit in the plan forever. Required minimum distributions must begin by April 1 of the year after you turn 73. If you are still working for the employer sponsoring the plan at that age and the plan allows it, you can wait until you actually retire. Missing a required amount triggers a 25% excise tax on the shortfall, dropping to 10% if you fix it within two years.10Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
Each year the plan sends you a Form 1099-R showing the gross distribution in Box 1, the taxable amount in Box 2a, and any federal tax withheld in Box 4.11Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498 For a 414(h) distribution, Boxes 1 and 2a usually match.
What the Social Security Fairness Act Changed
Public employees receiving a 414(h) pension used to face a second tax-related issue through the Windfall Elimination Provision and the Government Pension Offset, which reduced Social Security retirement benefits and spousal or survivor benefits for people drawing pensions from work not covered by Social Security. Both provisions were repealed by the Social Security Fairness Act, signed on January 5, 2025, with the repeal applying to benefits payable for January 2024 and later.12Social Security Administration. Social Security Fairness Act: Windfall Elimination Provision (WEP) and Government Pension Offset (GPO) Update Receiving a pension funded by 414(h) contributions no longer reduces your Social Security benefit.