As employees progress through their careers, their unused sick leave, vacation time, or other forms of special compensation can build up. For employers, these balances can represent more than an earned benefit. They can also create future budget, payroll tax, and administrative considerations when employees retire.
When accrued leave is paid directly as wages, the result may be a large one-time expense for the employer and a potentially higher taxable payout for the employee. A thoughtfully designed Special Pay Plan through your 403(b) retirement plan or retiree Health Reimbursement Arrangement (HRA) strategy may help turn that obligation into a meaningful retirement benefit while supporting the organization’s long-term financial planning.
The Challenge of Accumulated Leave Balances
Many employees, particularly those in education, government, healthcare, and other long-service industries, may retire with significant balances of unused sick leave or vacation time. Over time, these balances can grow into a meaningful liability that employers must plan for as employees approach retirement.
For employers, this creates several considerations:
Budgeting for future leave payout obligations
Managing large lump-sum payments upon retirement
Paying payroll taxes on eligible wage payouts
Coordinating accrued benefit liabilities with workforce planning goals
Communicating options clearly to employees nearing retirement
As more experienced employees reach retirement age, these obligations can become increasingly important to manage. Employers may want a solution that helps preserve the value of the benefit for employees while also reducing the impact of large retirement payouts on the organization.
What a Special Pay Retirement Plan Is
A Special Pay Retirement Plan is a way to handle certain forms of compensation, such as accrued sick leave, vacation pay, retirement incentives, or other special compensation. Instead of an employee receiving these funds as compensation, it would be a non-elective contribution to their 403(b) retirement plan.
In other words, employers could deposit accrued sick leave into an employee’s retirement plan or a retiree HRA as an employer contribution, instead of allowing them to choose how it’s distributed. This approach may help employees save more for retirement while creating potential payroll tax efficiencies for the employer.
In many cases, the value of accrued leave can be used to support employees in one or two ways:
403(b) Special Pay Plan: Helps employees build retirement income through additional retirement plan contributions.
Retiree HRA: Helps employees prepare for eligible healthcare expenses and insurance premiums in retirement.
Employees can contribute accrued leave to these plans in two ways:
Option 1: Employees are allowed to elect to defer compensation associated with accrued leave into their 403(b) account, subject to plan and IRS limits.
Option 2: Employer-mandated, non-elective contributions made on behalf of retired employees, which can continue for up to five years after termination under applicable rules.
This flexibility allows employers to align the program with their workforce needs, benefit strategy, and retirement planning objectives. Contributing eligible accrued sick leave or vacation pay to a retirement plan may also avoid Social Security and Medicare (FICA) tax that would apply if the amount were paid directly as wages. This could help both employers and employees save on payroll tax while increasing retirement plan contributions. The specific tax benefits depend on the plan’s design, participant eligibility, and applicable rules.
How Employers May Benefit
Potential employer benefits may include:
Easier planning for retirement payout obligations
Convert existing leave liability into a retirement benefit
Support for workforce transitions and succession planning
Enhanced recruitment and retention efforts
A more competitive benefits package for long-tenured employees
Boost the value of the organization’s retirement benefits
These programs may be especially valuable for employers with employees who have accumulated substantial leave balances over many years of service. Instead of viewing unused leave only as a future payout obligation, employers can use a Special Pay Retirement Plan or retiree HRA strategy to help provide lasting value to employees as they transition into retirement.
How Employees May Benefit
Employees often value solutions that help them maximize the benefits they’ve earned over their careers. When eligible accrued leave is contributed to a retirement plan or retiree HRA, employees may be able to use those dollars to help support retirement income or future healthcare needs.
Potential employee benefits may include:
Additional retirement plan contributions
Opportunity for tax-deferred growth, when applicable
Reduced payroll tax under certain plans
Improved retirement preparedness
Dedicated funds for eligible healthcare expenses through a retiree HRA
Convert unused leave into long-term financial support
This helps retiring employees keep their leave benefits while supporting broader financial readiness.
Consider this hypothetical example:
Assume 10 employees are retiring in the same year with a combined total of $100,000 in unused sick leave or vacation pay. Without a Special Pay Retirement Plan, the employer may need to pay that amount as a lump sum, plus 7.65% in FICA tax, for a total cost of $107,650. Employees may also owe income tax on their portion, potentially at a higher tax rate.
With a Special Pay Retirement Plan, the employer may save $7,650 in FICA tax and may be able to spread the $100,000 contribution over a period of up to five years, depending on the plan design and applicable rules. Employees may also benefit by deferring income tax until the funds are withdrawn from the retirement account.
Choosing the Right Solution: 403(b) Special Pay Plan or Retiree HRA
The right approach depends on the organization’s goals and the needs of its employees. Employers may choose to offer a 403(b) Special Pay Plan, a retiree HRA, or a combination of both. Some organizations prioritize helping employees build retirement income, while others focus on helping retirees prepare for healthcare expenses. Offering both solutions may provide employees with greater flexibility and a more comprehensive retirement benefit strategy.
403(b) Special Pay Plan
A 403(b) Special Pay Plan may be ideal for employers who want to help employees build retirement assets. Funds may be used for any purpose upon retirement, contributed funds may continue to grow tax deferred until withdrawn, and assets may be rolled into other eligible retirement accounts if permitted.
Retiree HRA
A retiree HRA may be a strong fit when the employer wants to help employees prepare for healthcare costs in retirement. Funds are generally used for eligible healthcare expenses and insurance premiums, and qualified reimbursements are generally tax free.
Both options can help employers provide a more meaningful retirement benefit while addressing different employee needs.
What Employers Should Know
Successful implementation starts with thoughtful plan design. Employers should:
Review plan documents and governing agreements
Confirm eligible contribution sources and applicable contribution rules
Coordinate contributions with annual plan and IRS limits
Define eligibility criteria and participation requirements
Align employee communications with plan provisions
Establish administrative processes for contributions and recordkeeping
Ensure the program supports broader retirement and benefits strategies
It is also important to clearly define:
Who is eligible
Which types of accrued leave or special compensation may be included
Whether contributions are mandatory or elective
How and when contributions will be made
How the program will be communicated to employees
How the arrangement fits with existing retirement plan strategies
Because tax treatment depends on plan design, participant eligibility, and applicable regulations, employers should work with appropriate legal, tax, and plan advisors before implementing a program.
Administration Doesn't Have to Be Complicated
Some employers may hesitate to explore alternative payout strategies due to administration and compliance concerns. By partnering with American Fidelity, employers can get help navigating these concerns and take actionable steps to optimize their benefits strategies, such as:
Evaluate available plan design options
Review administrative considerations
Support employee education efforts
Communicate program changes effectively
Coordinate implementation with existing retirement plan strategies
Looking Ahead
This blog is up to date as of August 2026 and has not been updated for changes in the law, administration, or current events. American Fidelity does not provide financial, legal, or tax advice. Consult an attorney or a tax professional regarding your specific situation.
