If you work for a government entity that has a state retirement system, your participation in the program might be mandatory. The system includes retirement and disability programs. Your employer may also provide optional cafeteria plan benefits, which typically include health and life insurance, and flexible spending accounts. A cafeteria plan does not change the type of state retirement benefits that are available to you upon retirement, but it may affect the amount.
Your payroll deductions for your cafeteria plan benefits are done on a before-tax basis. Qualified benefits are not subject to federal income tax, Social Security tax, Medicare tax and, in most cases, state income tax. Because they are excluded from taxation, they reduce your taxable income, which results in tax savings. This process may cause a slight reduction in your Social Security benefits when you retire. When compared with the tax savings an employee receives, the reduction in Social Security benefits is typically insignificant.
State retirement benefits are calculated using the participant’s highest average salary. Because the salary used to pay for your cafeteria plan is not subject to taxation, it is also not included in the salary that your highest average salary is based on. This reduction is salary ultimately lowers the amount of contributions you make to your state retirement account and your state benefits, which typically depend on your service credits and retirement age. For example, you might receive a monthly service credit for each month of employment if your salary is equal to or exceeds 80 times the federal minimum wage. Because a cafeteria plan reduces your salary, it could affect whether you earn enough monthly credits. If you do not have sufficient credits, it would cause a decrease in your state retirement benefits.
State Retirement and Social Security Benefits
If you have a government pension plan, you might be eligible for both state retirement and Social Security benefits when you retire. In this case, your Social Security benefits may be reduced, but not your state retirement benefits. This would happen if you are subject to the Windfall Elimination Provision, which Congress made effective as of 1983. The WEP may impact you if you have a pension plan and worked for a government agency that is not covered by Social Security. For example, if you worked at a job in which you did not pay Social Security tax, but worked in other jobs long enough to qualify for Social Security benefits, WEP might apply to you.
The WEP has a specific formula that reduces your Social Security benefits if you are also receiving pension benefits. Social Security benefits are generally calculated to replace a percentage of an employee’s earnings before retirement. Low-wage workers receive more monthly benefits than high-paid workers. Before WEP, workers who were not covered by Social Security received benefits as though they were low-wage workers. Congress passed WEP to remove that advantage.
Grace Ferguson has been writing professionally since 2009. With 10 years of experience in employee benefits and payroll administration, Ferguson has written extensively on topics relating to employment and finance. A research writer as well, she has been published in The Sage Encyclopedia and Mission Bell Media.