State government faces an unexpected $5 million to $6 million increase in personnel costs in a couple of years but the impact of an Internal Revenue Service ruling could have an even bigger impact on budgets of local governments and school districts.
State officials have been informed by the IRS they must start withholding Social Security and Medicare taxes from employees’ contributions to their pension plans and the state — or local government employer — will have to match those contributions.
The 7.65 percent deductions have always applied to most of state workers’ pay but for many years it wasn’t applied to that portion contributed to their retirement systems.
That was because of an opinion the IRS issued in a private letter in response to questions from the administration of Martha Layne Collins who was governor from 1983 to 1987, according to Mary Lassiter, Secretary of Gov. Steve Beshear’s executive cabinet.
Lassiter said the state for decades relied on that opinion which said contributions to the retirement funds weren’t subject to withholding provisions of the Federal Insurance Contributions Act or FICA to fund Social Security, survivor benefits and Medicare.
Lassiter said the IRS “subsequently changed course and said we could no longer rely on the (previous) ruling. It also affects other states, not just Kentucky.”
It affects employees’ net pay too, because 7.65 percent of the amount contributed to pensions will now be withheld for FICA, an amount the state must match.
Kentucky learned about the change about a year ago and has been negotiating with the IRS on how to comply.
“We’ve not signed any agreement with IRS, but we are in discussions with them,”
Lassiter said. But the direction of the discussions generally have included a start date of January 2017 for withholding and have not included a “look-back” requirement for payment for previous years.
That factors large in considering a challenge to the IRS decision, said J.D. Chaney, deputy director of the Kentucky League of Cities whose members face additional costs to their budgets as well.
“Absent any sound legal foundation, we’re not considering a challenge because of the possibility of past liability,” Chaney said.
He hasn’t calculated the impact to local governments, but Chaney noted cities employ hazardous duty personnel in fire and police departments who receive larger pension contributions so the new withholding amounts are likely greater for cities.
Spokespersons for the Kentucky Department of Education and Kentucky School Boards Association referred questions about the impact on school districts to Beau Barnes, deputy executive secretary and general counsel for the Kentucky Teachers Retirement System.
Barnes estimates the total cost statewide will be about $55 million a year, including schools and local governments.
While most employees won’t like the additional withholding, Lassiter said it will ultimately increase their Social Security benefits, except for teachers. Teachers don’t receive Social Security benefits, although they contribute 1.45 percent of pay to the Medicare portion of FICA, an amount matched by their school board.
Barnes said the withholding won’t affect the financial soundness of state retirement systems or how much the legislature must contribute to them. Kentucky’s retirement plans are among the most troubled nationally and lawmakers continue to struggle with ways to shore them up.
It’s not known how much Beshear’s recent decision to increase the minimum wage for about 780 state employees to $10.10 an hour or recent raises for engineers in the Transportation Cabinet will impact the final FICA withholding cost to the state.
But $5 million to $6 million is a relatively small amount in a $10 billion General Fund. Still, House Budget Chairman Rick Rand, R-Bedford, said it will make lawmakers’ jobs harder.
“It’s nothing we can’t overcome,” Rand said. But much of the budget is tied to fixed costs and lawmakers have discretionary control over only a very small portion of the $10 billion.
“This will just mean it’s that much less and that much harder to do things we need to do in other areas,” Rand said.
Rand and his Senate counterpart, Sen. Chris McDaniel, R-Taylor Mill, only recently learned of the problem. McDaniel said he hasn’t “been officially notified” about the likely additional expense, but he has begun to study its potential budget impact.