Contributions to a 414(h) plan are not tax-exempt. They are tax-deferred: the money leaves your paycheck before federal income tax is calculated, but you will owe ordinary income tax on every dollar — original contributions and investment earnings alike — when you draw the money in retirement. And for most public employees, Social Security and Medicare taxes still come out of that contribution today. So the paycheck feels lighter on income tax, but the tax obligation has been postponed, not erased.
Why the Contribution Is Deferred Rather Than Exempt
Section 414(h)(2) of the Internal Revenue Code lets a state or local government employer formally “pick up” mandatory employee pension contributions and treat them 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. What changes is the legal classification, and that reclassification is what excludes the amount from your current federal taxable income.
The pick-up isn’t automatic. The governing body — a city council, state legislature, or retirement board — has to pass a resolution or ordinance adopting it, and the plan document must authorize it.2Internal Revenue Service. Employer Pick-Up Contributions to Benefit Plans Without that formal action, the same paycheck deduction would be treated as after-tax employee money and would produce no deferral at all.
This is also different from a 401(k). A 414(h) pick-up almost always involves a mandatory contribution you can’t opt out of. The tax result on the paycheck feels similar to a pre-tax 401(k) deferral, but the legal mechanism — an employer pick-up of a required employee contribution — is what makes it work.
What “Deferred” Means for Federal Income Tax
The deferral works on both ends of your career. In the year you earn the money, the contribution is excluded from your taxable income. If your salary is $80,000 and you contribute $6,000 through a 414(h) pick-up, you owe federal income tax on $74,000 for that year. The $6,000 grows without being taxed along the way.
When you eventually take distributions, every dollar comes out as ordinary income at whatever bracket applies that year. There’s no capital gains rate and no partial exclusion for the amounts you originally put in, because you never paid income tax on them. Most states follow the federal treatment and exclude 414(h) contributions from state income tax in the contribution year as well, though the specifics vary by state code.
The financial logic is straightforward: a lower tax bill during your working years in exchange for a tax bill in retirement, when your income is often lower.
FICA Still Applies to Most 414(h) Contributions
Social Security’s 6.2% tax and Medicare’s 1.45% tax follow different rules than income tax does.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 distinguishes two versions. When the employer reduces your salary by the contribution amount — the setup used in the large majority of 414(h) arrangements — the contribution counts as a salary reduction and is 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 true supplement, the contribution may be excluded from FICA. That second version is uncommon, so most public employees do pay Social Security and Medicare tax on their 414(h) money.
Two situations complicate the FICA picture. Employees hired by a state or local government before April 1, 1986 who have worked continuously for that same employer, belong to a public retirement system, and were never brought into Social Security through a Section 218 Agreement remain exempt from FICA entirely.4Internal Revenue Service. Medicare Continuing Employment Exception Any break in employment with that employer ends the exemption permanently.5Social Security Administration. Mandatory Medicare Coverage Separately, many state and local governments have signed Section 218 Agreements bringing their workers into Social Security, in which case both Social Security and Medicare tax apply to the full wage base including the 414(h) amount.6Social Security Administration. Section 218 Agreements
High earners should also know that because the contribution is generally included in Medicare wages, it counts toward the 0.9% Additional Medicare Tax that applies once Medicare wages exceed $200,000 for single filers or $250,000 for joint filers.7Internal Revenue Service. Topic No. 560, Additional Medicare Tax
Checking the Deferral on Your W-2
Your W-2 is the fastest way to confirm the pick-up is doing its job. Box 1 (“Wages, Tips, Other Compensation”) should show your gross salary minus the 414(h) contribution. On $70,000 of salary with a $5,000 contribution, Box 1 reports $65,000. That reduced figure is what feeds your federal income tax calculation.
If you’re subject to FICA, Box 3 (“Social Security Wages”) and Box 5 (“Medicare Wages and Tips”) tell a different story. Both will typically show the full $70,000, because the contribution stays in the FICA wage base. Box 3 caps at the annual Social Security wage base — $184,500 for 2026 — while Box 5 keeps counting past it.8Social Security Administration. Contribution and Benefit Base
The gap between Box 1 and Boxes 3 and 5 is your confirmation that the deferral is working. Unlike a 401(k) elective deferral, which appears on its own line in Box 12 (Code D), a 414(h) contribution has no dedicated W-2 box. Some employers list it in Box 14 (“Other”), but that’s optional. If Box 14 is blank, you can back into the number by subtracting Box 1 from your known gross salary, adjusted for any other pre-tax deductions such as health insurance premiums.
How Much Can Be Deferred This Way
Because 414(h) contributions are mandatory and set by the plan, you generally don’t choose the amount. But federal limits still cap what can flow through the pick-up. For plans structured as defined contribution accounts, total employer plus employee contributions cannot exceed $72,000 in 2026 under Section 415(c).9Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions The IRS treats 414(h) pick-up contributions as employer contributions for this limit.10eCFR. 26 CFR 1.415(c)-1 – Limitations for Defined Contribution Plans Most public employees won’t come close to $72,000 through mandatory pension contributions alone, but the limit can matter if you also participate in a supplemental defined contribution plan through the same employer.
For defined benefit pension plans, where your retirement benefit is calculated by formula rather than by account balance, the Section 415(b) cap of $290,000 in 2026 applies to the annual benefit payable at retirement rather than to the money going in.9Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
The Pension No Longer Reduces Your Social Security Benefit
Public employees whose pensions came from work not covered by Social Security used to see their Social Security benefits reduced by the Windfall Elimination Provision or, for spouses and survivors, the Government Pension Offset. Both provisions were repealed by the Social Security Fairness Act, signed into law on January 5, 2025, retroactive to benefits payable for January 2024 and later.11Social Security Administration. Social Security Fairness Act: Windfall Elimination Provision (WEP) and Government Pension Offset (GPO) Update Receiving a pension funded through a 414(h) plan no longer reduces the Social Security benefit you or your spouse would otherwise collect.