Employee Rights Attorney

Mission Viejo, California

Q: I am a public employee hoping to retire within one or two years. I will receive a payoff on accumulated sick leave. A retired co worker said the federal government does not tax vacation leave, sick leave, compensatory time, service pay, disability pay and death benefits under Section 457 of the IRS Code. My tax preparer says my sick leave payoff is taxable.

A: “Both are right,” says employee rights attorney Peter W. Taylor of Don D. Sessions Law Corp., Mission Viejo. “Sick leave payoff is taxable like other income. A Section 457 plan enables public and nonprofit employees to set aside money on a pretax basis through an employer sponsored plan. Section 457 plans don’t apply to ‘private sector’ employees.

“Sick leave, vacation leave, compensatory time, severance pay, disability pay and death benefits are not treated as Section 457 plans and do not get taxed under Section 457 distribution rules. In the past, there was concern that the IRS might apply Section 457 taxation to accrued benefits never taken.

“Accrued vacation, sick leave payoffs and severance pay are taxable income, generally paid through payroll. Vacation, sick leave and compensatory time are compensated benefits in lieu of work attendance. There may also be circumstances where disability pay and death benefits may be exempt or partially exempt from taxation.

“You are talking about ‘deferred compensation’ in a Section 457 plan on one hand, and taxable income on the other.

“Deferred compensation means deferring income from taxation until retirement or other qualifying event, when income is distributed and taxed in accordance with applicable IRS rules.”