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can provide employees with membership in a public retirement system as an alternative to mandatory Social Security coverage.

As a supplement to the Social Security and public retirement systems information provided in this publication, refer to IRS.gov/FSLG.

This chapter provides information about the requirements a retirement system must meet to qualify as an alternative to Social Security coverage.

Public Retirement Systems (FICA Replacement Plans)

A public retirement system, as defined in IRC Section 3121(b)(7)(F) and Treas. Reg. Section 31.3121(b)(7)-2, is a pension, annuity, retirement or similar fund or system maintained by a state or local government that provides a retirement benefit to the employee comparable to the benefit provided under the Old-Age portion of the Old-Age, Survivors and Disability Insurance (Social Security) part of FICA.

To be a retirement system for this purpose, the plan must provide a minimum retirement benefit. In this context, the term “employer” is a state, political subdivision or instrumentality. The term “employee” is used here only to refer to an employee of a state, political subdivision or instrumentality.

Note: A “public retirement system” for this purpose is not required to be a qualified plan within the meaning of ERISA. The ERISA provisions relate to the tax treatment of contributions and benefits of employee plans and are irrelevant to the coverage issues addressed here. To avoid confusion, this publication does not use the term “qualified” to refer to public retirement systems. For mandatory coverage purposes, the employee may be a member of any type of retirement system, including a system that is nonqualified under ERISA (for example, a Section 457 plan), as long as the plan provides the minimum level of benefits required for a public retirement system. These requirements are discussed below and in Treas. Reg. Section 31.3121(b)(7)-2(e) and Revenue Procedure 91-40.

For purposes of determining whether mandatory coverage applies for an employee holding more than one position, Social Security is NOT a public retirement system.

Example: An individual holds two positions with the same political subdivision. The wages earned in one position are subject to Social Security and Medicare tax under a Section 218 Agreement; the other position is not covered. The Social Security system is not a retirement system for this purpose. Thus, mandatory Social Security coverage applies to service in the other (non-218) position unless the employee is a member of a public retirement system with respect to that position. See Treas. Reg. 31.3121(b)(7)-2(e)(1).

In general, there are two types of public retirement systems that may meet the minimum benefit requirement — the defined contribution plan and the defined benefit plan.

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Defined Contribution Plan

A defined contribution plan provides an individual account for each participant. The participants’ benefits from this plan are based solely on the amount contributed to their account and any income, expenses, gains or losses that may be allocated to their account. See IRC Section 414(i).

A defined contribution plan that satisfies the definition of a retirement system under Treas. Reg. 31.3121(b)(7)-2(e)(2)(iii) must provide for an allocation to the employee’s account of at least 7.5% of the employee’s compensation during any period under consideration . A variety of plan types could meet the requirement; for example, plans established under IRC Sections 401(a), 403(b) or 457. Contributions from both the employer and the employee may be used to make up the 7.5%. Matching contributions by the employer may be taken into account for this purpose. A plan with only employee contributions would also satisfy the minimum benefit requirement, provided the contributions constitute at least 7.5% of compensation. However, the percent cannot include any earnings on the account.

Compensation

For a defined contribution plan, the definition of “compensation” used to determine whether the benefit is sufficient must include at least the employee’s base pay, provided that the definition of “base pay” is reasonable. Thus, for example, a defined contribution retirement system may disregard overtime pay; bonuses or single-sum amounts received on account of death or separation from service; amounts received under a bona fide vacation, compensatory time or sick pay plan; or amounts received under severance pay plans. Any compensation in excess of the Social Security contribution wage base for that year ($132,900 in 2019 and $137,700 in 2020) may also be disregarded for this purpose.

Example: A political subdivision maintains an elective defined contribution plan that is a retirement system within the meaning of IRS regulations. The plan is on a calendar year. An employee contributes to the plan at a rate of 7.5% of base pay. Assume that the employee's compensation will reach the Social Security maximum contribution base in October. The employee is a qualified participant in the plan for the entire plan year, even if the employee ceases to contribute to the plan after reaching the maximum contribution base. See Treas. Reg. 31.3121(b)(7)-2(e) (2)(iii)(B).

Generally, for an employee who holds more than one position with the same employer, all compensation with that employer is considered in applying the 7.5% test.

However, at the employer’s option, compensation from only one position may be considered, if that position is not parttime, temporary or seasonal. See Treas. Reg. 31.3121(b)(7)-2(c)(2)(iv).

Reasonable Interest Rate Requirement

Generally, a defined contribution retirement system must credit the employee’s account with earnings at a reasonable rate, under all the facts and circumstances. Alternatively, employees’ accounts may be held in a separate trust subject to general fiduciary standards and credited with actual earnings of the trust fund. Whether the interest rate is reasonable is determined after reducing the rate to adjust for the payment of any administrative expenses. See Treas. Reg. 31.3121(b) (7)-2(e)(2)(iii)(C).

Defined Benefit Plan

For purposes of determining whether it qualifies as a public retirement system, a defined benefit plan is any plan other than a defined contribution plan, including a hybrid plan. A defined benefit plan (including a hybrid plan) requires the use of an actuary to calculate benefits based on a formula, generally based on age, years of service and salary level.

A defined benefit retirement system that qualifies as an alternative to Social Security provides for a retirement benefit to the employee that is comparable to the benefit provided by the Social Security part of FICA. Generally, a plan meets the requirement if the benefit under the system is at least 1.5% of average compensation during an employee’s last three years of employment, multiplied by the employee’s number of years of service . Apply the formulas in Revenue Procedure 91-40 and the IRS regulations to determine whether a defined benefit retirement system meets this requirement.

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Who Is a Qualified Participant?

For an employee to be excluded from mandatory Social Security coverage, the employing entity must maintain a retirement system within the meaning of IRC Section 3121(b)(7)(F) and the employee must be a qualified participant in that system, as defined in IRC Section 3121(b)(7)(F) and Treas. Reg. 31.3121(b)(7)-2(d). This test must be applied to each employee separately. An entity may maintain a retirement system in which not every employee is a qualified participant. For both a defined contribution plan and a defined benefit plan, the determination of whether an individual is a qualified participant is made as services are performed; however, there are different tests to determine participation.

Qualified Participant in a Defined Contribution Retirement System

An employee is a qualified participant in a defined contribution retirement system with respect to services performed on a given day if, on that day, the employee has satisfied all conditions (other than vesting) for receiving an allocation to their account (exclusive of earnings) that meets the minimum retirement benefit requirement. The benefit must be calculated on compensation during a period ending on that day and beginning on or after the beginning of the plan year of the retirement system. This is the case regardless of whether the allocations were made or accrued before the effective date of IRC Section 3121(b)(7)(F).

Example 1: A state-owned hospital maintains a nonelective defined contribution plan. Under the terms of the plan, employees must be employed on the last day of a plan year to receive any allocation for the year. Employees may not be treated as qualified participants in the plan before the last day of the year.

Example 2: The situation is the same as in Example 1, except that under the terms of the plan, an employee who terminates service before the end of a plan year receives a pro rata portion of the allocation they would have received at the end of the year, that is based on compensation earned since the beginning of the year. If the pro rata allocation available on a given day would meet the minimum retirement benefit requirement with respect to compensation from the beginning of the plan year through that day (or some later day), the employee is treated as a qualified participant in the plan on that day.

Example 3: A political subdivision maintains an elective defined contribution plan. The plan operates on a calendar year. It has two open seasons—in December and June—when employees can change their contribution elections. In December, an employee elects not to contribute to the plan. In June, the employee elects (beginning July 1) to contribute a uniform percentage of compensation for each pay period to the plan for the remainder of the plan year. The employee is not a qualified participant in the plan during the period January-June, because no allocations are made to the employee’s account during that time. If the level of contributions during the period of July-December meets the minimum retirement benefit requirement with respect to compensation during that period, the employee is treated as a qualified participant during that period.

Example 4: Assume the same facts as in Example 3, except the plan allows participants to cancel their elections in cases of economic hardship. In October, the employee suffers an economic hardship and cancels the election, effective November 1. If the contributions during the period July-October are high enough to meet the minimum retirement benefit requirement with respect to compensation during that period, the employee is treated as a qualified participant during that period. In addition, if the contributions during the period July-October are high enough to meet the requirements for the entire period July-December, the employee is treated as a qualified participant in the plan throughout the period July-December, even though no allocations are made to the employee’s account in the last two months of the year. There is no requirement that the period used to determine whether an employee is a qualified participant on a given day remain the same from day to day, as long as the period begins on or after the beginning of the plan year and ends on the date the determination is being made. See Treas. Reg. 31.3121(b)(7)-2(d)(1)(ii).

Qualified Participant in a Defined Benefit Retirement System

An employee is a qualified participant in a defined benefit retirement system with respect to services performed on a given day if on that day:

• The employee is (or ever has been) an actual participant in the retirement system, and

• The employee actually has a total accrued benefit that meets the minimum retirement benefit requirement.

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An employee may not be treated as an actual participant or as actually having an accrued benefit for this purpose to the extent that the participation or benefit is subject to any conditions (other than vesting) that have not been satisfied. The disqualifying conditions might include a requirement that the employee attain a minimum age, perform a minimum period of service, make an election to participate or be present at the end of the plan year to be credited with an accrual.

Example: A political subdivision maintains a defined benefit plan. Under the terms of the plan, service during a plan year is not credited for accrual purposes unless a participant has at least 1,000 hours of service during the year. For purposes of determining whether mandatory Social Security coverage applies, benefits that accrue only upon satisfaction of this 1,000-hour requirement may not be taken into account in determining whether an employee is a qualified participant in the plan before the 1,000-hour requirement is satisfied. See Treas. Reg. 31.3121(b)(7)-2(d)(1)(i).

Part-Time, Seasonal, Temporary Employees

Special rules apply to part-time, seasonal and temporary employees for purposes of determining whether they are qualified participants in a public retirement system. To be exempt from mandatory Social Security coverage, these employees must not only be qualified participants; they must be fully vested in their benefits. This means the benefits cannot be forfeited. If a part-time, seasonal or temporary employee (as defined below) is not a qualified participant in a public retirement system with benefits fully vested from the first day of employment, that employee is subject to mandatory Social Security and Medicare tax until the employee becomes fully vested.

The special vesting requirement is considered to be met if a part-time, seasonal or temporary employee in a defined contribution plan has the right to receive a single sum payment of at least 7.5% of the compensation the employee earned while covered under the retirement system (plus interest) when the employee separates from employment.

Part-Time Employees

For purposes of applying the qualified participant test, part-time employees are those who normally work 20 hours or less per week. (This definition of “part-time” should not be confused with a definition of “part-time” that may be used for a Section 218 Agreement.) If mandatory coverage applies, part-time positions cannot be excluded; but part-time positions may be excluded from coverage under a Section 218 Agreement, at the option of the state. Contact the State Social Security Administrator to determine the definition of part-time positions under the state’s Section 218 Agreement.

A special rule provides that a teacher employed by a post-secondary educational institution (a community or junior college, post-secondary vocational school, college, university or graduate school) is not considered part-time if the teacher normally teaches classroom hours of one-half or more of the number of classroom hours normally considered to be fulltime employment.

Example: A community college treats a teacher as a full-time employee if the teacher is assigned to work 15 classroom hours per week. A new teacher is assigned to work eight classroom hours per week. Because the assigned classroom hours of the teacher are at least one-half of the hours designated by the school as constituting full-time employment, the teacher is not a part-time employee. See Treas. Reg. 1.3121(b)(7)-2(d)(2)(iii)(A).

Seasonal Employees

For purposes of applying the qualified participant test, a seasonal employee is any employee who normally works full-time less than five months a year. Thus, for example, individuals who are hired by a political subdivision during the tax return season to process incoming returns and work full-time over a three-month period are seasonal employees. See Treas. Reg. 31.3121(b)(7)-2(d)(2)(iii)(B).

Temporary Employees

For purposes of applying the qualified participant test, a temporary employee is one who performs services under a contractual arrangement that is expected to last two years or less. Under this rule, a teacher under an annual contract may or may not be a temporary employee. Possible contract extensions must be considered in determining the duration of a contractual arrangement if there is a significant likelihood that the employee’s contract will be extended. Contract

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extensions are considered likely to occur if, on average, 80% of similarly situated employees have had bona fide offers to renew their contracts in the immediately preceding two academic or calendar years. Contract extensions are also considered significantly likely to occur if the employee has a history of contract extensions in the current position. See Treas. Reg. 31.3121(b)(7)-2(d)(2)(iii)(C).

Individuals Employed in More Than One Position

If an employee is not covered by a Section 218 Agreement but is a member of a retirement system for one full-time position, the employee is generally treated as a member of a retirement system for any other position with the same employer.

Example: An individual is employed full-time by a county and is a qualified participant in its retirement plan. In addition to this full-time employment, the individual is employed part-time in another position with the same county. The part-time position is not covered by the county retirement plan. Nevertheless, if the individual is a qualified participant in the retirement plan for the full-time position, the part-time position is excluded from mandatory Social Security coverage. See Treas. Reg. 31.3121(b)(7)-2(c)(2).

This rule does not apply to employment by two different employers.

Example: An individual is employed full-time by a state and is a member of its retirement plan and is also employed part-time by a city located in the state, but does not participate in the city’s retirement plan. The services of the individual for the city are not excluded from mandatory Social Security coverage, because the determination of whether services constitute employment for such purposes is made separately for each political subdivision for which services are performed. See Treas. Reg. 31.3121(b)(7)-2(c)(2).

Whether an employee is part-time, seasonal or temporary is generally determined on the basis of service in each position in which allocations or benefits were earned. This determination generally does not take into account service in other positions with the same or different public employers. However, all an employee’s service in other positions with the same or different employers may be taken into account to determine whether an employee is a part-time, seasonal or temporary employee with respect to benefits under the retirement system provided that:

• The employee’s service in the other positions is or was covered by the same retirement system;

• All service aggregated for purposes of determining whether an employee is a part-time, seasonal or temporary employee (and related compensation) is aggregated under the system for all purposes in determining benefits (including vesting); and

  • The employee is treated at least as favorably as a full-time employee under the retirement system for benefit accrual purposes.

Example: Assume an employee works 15 hours per week for a county and 10 hours per week for a municipality, and both these employers contribute to the same statewide public employee retirement system. Assume further that the employee’s service in both positions is aggregated under the system for all purposes in determining benefits (including vesting). If the employee is covered under the retirement system with respect to both positions and is treated for benefit accrual purposes at least as favorably as full-time employees, then the employee is not considered a part-time employee of either employer. The requirement of being fully vested for determining the applicability of mandatory Social Security coverage does not apply. See Treas. Reg. 31.3121(b)(7)-2(d)(2)(iii)(D).

Alternative Lookback Rule

Under an alternative lookback rule, an employee may be treated as a qualified participant in a retirement system throughout a calendar year if the employee was a qualified participant in the system at the end of the plan year of the system ending in the preceding calendar year.

Example: An employee is a qualified participant in a retirement plan of a city on the last day of the plan year, May 31, 2018. If the alternative lookback rule is used, no liability for Social Security tax exists for the employee for calendar year 2019. See Treas. Reg. 31.3121(b)(7)-2(d)(3).

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For the first year of participation, an employee who participates in the retirement system may be treated as a qualified participant during the year only if it’s reasonable to believe that the employee will be a qualified participant on the last day of the plan year.

Former Participants

In general, the rules on qualified participants apply to former participants who continue to perform services for the employer or who return after a break in service.

Thus, for example, a former employee, with a deferred benefit under a defined benefit retirement system, who is reemployed by the same employer but does not resume participation in the retirement system, may continue to be a qualified participant in the system after becoming re-employed if the individual’s total accrued benefit under the system meets the minimum retirement benefit requirement (taking into account all periods of service, including current service). If this is so, the employer is not required to withhold and pay Social Security tax, or make additional payments to the retirement system on his behalf. The individual’s status as a qualified participant must be continually re-evaluated, however, for employment of more than a short period. (Treas. Reg. 31.3121(b)(7)-2(d)(4)(i)).

Rehired Annuitants

A rehired annuitant is a retiree who is rehired by their employer or another employer that participates in the same retirement system as the former employer. A rehired annuitant is either receiving a retirement benefit from that retirement system, or has reached retirement age under the retirement system.

Rehired annuitants are excluded from mandatory Social Security coverage.

Example: A teacher retires from service with a school district that participated in a statewide teachers’ retirement system and did not have a Section 218 Agreement. The teacher begins to receive benefits from the system and later becomes a substitute teacher in another school district that participates in the same statewide system. The employee is treated as a rehired annuitant and is not subject to mandatory Social Security tax, but is subject to Medicare tax. See Treas. Reg. 31.3121(b)(7)-2(d)(4)(ii).

However, if an employee is rehired to perform services in a state or local government position that is covered for Social Security under a Section 218 Agreement, services in that position are covered for Social Security. If an individual returns to work for an employer under mandatory coverage, the employment is subject to the mandatory coverage.

Note: Retirees rehired after March 31, 1986, are subject to the Medicare tax regardless of whether they qualify as rehired annuitants for Social Security purposes.

Frequently Asked Questions

1. What is a “public retirement system” for purposes of the mandatory coverage rules? A “public retirement system” (sometimes referred to as a “FICA replacement plan” or simply as a “retirement system”) is a pension or other retirement plan maintained by a public employer that meets the requirements of IRC Section 3121(b)(7)(F). See Revenue Procedure 91-40 and Treas. Reg. 31.3121(b)(7)-2. These requirements must be met for a retirement system to be used as an alternative to mandatory Social Security coverage. A retirement system may be a pension, annuity, retirement or similar fund or system established by a state or political subdivision. The system need not be created by the legislature of the state, nor does it have to be a plan under which the benefits are guaranteed by the state constitution. A retirement system can include a group annuity policy purchased by the state or political subdivision from a private insurance company. Whether a system qualifies as a “public retirement system” does not depend on whether it meets the requirements to be a qualified plan under the ERISA. [IRS]

2. What does it mean to be a qualified participant in a retirement system? To be a qualified participant, a member must actually participate in the system. An employee who is eligible for an optional system, but decides not to participate, will be subject to mandatory Social Security tax. Under an alternate rule, an employer is entitled to treat an employee as a qualified

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participant for the entire year if they were a qualified participant in the retirement system on the last day of the plan year ending in the previous calendar year. [IRS]

3. How are part-time, seasonal and temporary workers defined for purposes of determining whether they are qualified participants in a public retirement system under IRC Section 3121(b)(7)(F)? A part-time employee normally works 20 hours or less per week. A seasonal employee may work full-time, but for less than five months a year. In the case of teachers above the high-school level, part-time is defined as less than one-half the classroom hours designated as full-time by the school. A temporary employee performs services under a contractual arrangement of two years or less. Possible contract extensions must be considered in determining the duration of a contractual arrangement if there is a significant likelihood that the employee’s contract will be extended. Future contract extensions are considered likely if (1) on average 80% of similarly situated employees have had bona fide offers to renew their contracts in the immediately preceding two academic or calendar years or (2) the contract history of an employee indicates that the employee is not a temporary employee. [IRS]

4. Are there special vesting rules for part-time, seasonal and temporary workers? For part-time, seasonal and temporary employees to be qualified participants in an employersponsored retirement plan, they must be immediately and fully (100%) vested in the plan. The vesting requirement for a defined contribution plan is met if an employee has a nonforfeitable right to receive a payment equal to 7.5% of the compensation the employee earned while participating in the system plus a reasonable rate of interest. [IRS]

5. If a local government participates in a statewide retirement system, is the plan considered “established” by the employer? Yes. The fact that each local government is a separate employer for tax purposes is irrelevant. Even though the plan is not maintained by the local government, it is offered through that entity as an employer and is considered established by the employer. [IRS]

6. For new employees entering a retirement system, is there any waiting period for coverage during which mandatory Social Security and Medicare taxes do not have to be paid? If a full-time employee can be enrolled in the plan by the first day of the first full calendar month of service, Social Security and Medicare taxes do not have to be paid during the partial month in which they begin work. This rule does not apply to part-time, seasonal and temporary employees.

[IRS]

7. Is a retirement system that does not cover all employees a “retirement system” within the meaning of Treas. Reg. 31.3121(b)7-2? A retirement system is not required to cover all employees; it may be a retirement system for some employees and not for others. The coverage determination is made separately for each individual.

[IRS]

8. A teacher who is a participant in a retirement system during the academic year also works a few hours per week in the summer in the school library. The library job is not covered by a Section 218 Agreement or by the public retirement system because it does not fall during the normal 10-month school year. Are the wages for the summer job subject to Social Security and Medicare taxes? The wages are not subject to Social Security taxes because the teacher is a qualified participant in the public retirement system with respect to their full-time job. A teacher who is expected to be employed on a continuing basis qualifies for treatment as employed simultaneously in multiple positions with the same entity. Consequently, the determination may be made solely by reference to service in the teacher’s full-time position. The Medicare tax applies, unless the employee was hired prior to April 1, 1986, and qualifies for the continuing employment exception. [IRS]

9. A teacher retires from a school district, starts collecting a pension under the state retirement system, and returns to work for the same school district as a bus driver. The bus driving position is not covered by a Section 218 Agreement and is not covered by the state retirement system. Is the employee subject to mandatory Social Security tax on the wages as a bus driver? No. The employee is a rehired annuitant. He is deemed to be a qualified participant in the retirement system without regard to whether he continues to accrue a benefit. He is subject to Medicare tax because the continuing employment exception cannot apply since the original employment relationship terminated at retirement. [IRS]

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n Chapter 7