A frequent challenge encountered with many 401(k) and 403(b) plans is the treatment of compensation for purposes of employee and employer contributions. In fact, one the most common errors found during Department of Labor (DOL) and Internal Revenue Service (IRS) audits in retirement plans is—yes, you guessed it right—compensation error. Plan compensation has plethora of moving parts that adds to complexities in managing a plan, as compensation affects how plan contributions are determined and how annual compliance testing is performed. To properly determine compensation, it is essential to review plan’s definition of compensation and be aware of rules. Below is an overview of types of compensation available to plans, common adjustments made to these compensations that cause errors, as well as questions organizations’ benefit teams face every day.
Employers have some options in choosing employee compensation to use for determining employee deferral as well as employer matching or profit sharing contributions. Generally, all 401(k) or 403(b) plans base their definition of compensation on one of the three (3) safe harbor definitions included in IRS regulations:
- Form W-2 Compensation. This includes wages, salaries, fee for professional services and other compensation subject to federal tax withholding.
- Section 3401(a) Compensation. Equivalent to W-2 compensation with certain caveats such as exclusion of taxable group term life insurance in excess of $50,000.
- Section 415 Safe Harbor Compensation. This includes all compensation received by the employee that can be included in gross income with certain omissions, such as exclusions of employee’s receipts from unfunded unqualified plan, employees’ moving expenses, non-qualified stock option exercise, to name a few.
Typical compensation adjustments & errors
Whether the plan uses W-2 wages, Section 3401(a) wages, or Section 415 Safe Harbor compensation, the plan document will specify the compensation type and how to use it. Often, employers adjust their plan’s definition of compensation to exclude specific types of compensation, such as:
- Exclusion of bonuses
- Exclusion of commissions
- Exclusion of overtime pay
These common compensation adjustments can bring about common issues if plan is not administered properly.
Winterfell Inc. 401(k) Plan includes all gross compensation, including bonus, for purposes of all plan contributions. Employee Sansa elected to defer 8 percent. Winterfell Inc. matches dollar-for-dollar up to 4% of compensation. For pay period ending 12/15/18, Sansa’s payroll was processed as follows:
Employee name Sansa
Employee deferral (8%) $80
Employer match (up to 4%) $40
Is the above calculation correct? No—bonus should have been included in the calculation but was not. Sansa’s correct deferral withholding is $128 ($1,600 salary and bonus x .08 deferral election), and correct match is $64 ($1,600 x .04).
Compensation paid after termination of employment
A common question we receive is, “When a terminated employee’s final paycheck is issued after the date employment terminates, is the employee eligible to defer out of that final paycheck?” Generally, yes, but depends on when the payment is made and whether the former employee receives severance pay or post-severance pay). These two terms are often used interchangeably, but the definition of compensation specified in the plan document as well as the nature and the timing of the payment determine if the payment should be included or excluded for calculating contributions. Post-severance compensation is defined by the IRS as compensation that would have been paid if the severance had not occurred. Some examples of post-severance pay are:
- Unused vacation or sick pay
- Bonus or commissions earned by not yet paid
- Unless specifically excluded by the plan, the above should be included when determining contributions
True severance pay, on the other hand, is pay received by an employee as part of an agreement between the employer and former employee. Unlike post-severance pay, it is not a compensation that the former employee would have received had he or she continued employment. Former employees are not allowed to make 401(k) or 403(b) contributions from severance pay and employers should not count it when determining employer contributions.
Bran terminates from Winterfell Inc. on June 23, 2018. Bran had $5,000 worth of vacation and PTO accrual. He also received $10,000 severance pay. He elected to defer 10 percent of his salary into the plan. Plan’s definition of compensation does consider post-severance pay. When final payroll was processed for Bran on July 2, 2018, his payroll was processed as follows:
Post-severance pay $5,000
Severance pay $10,000
Employee deferral (10%) $500
Employer match (up to 4%) $200
Was the deferral and match calculated correctly? Yes! Severance pay of $10,000 was correctly NOT taken into account because it is not a true compensation.
How to avoid compensation definition failures
According to IRS, the plan sponsor or administrator should:
- When putting a new adoption agreement or plan document in place, perform a thorough page-by- page, line-by-line comparison of the key provisions of the plan.
- Have a copy of the plan document readily available to review plan provisions when operating the plan. Use the plan document itself, not a summary of benefits, to administer the plan.
- Perform a spot-check review on how to apply key provisions of the plan such as compensation, vesting and eligibility on a regularly scheduled basis, preferably before the end of the plan year.
- If failures are detected, fully correct them as soon as possible to avoid costly corrections.
Employers and their service providers that manage their plans should be aware of the plan’s definition of compensation and certain complexities that it carries. To prevent errors or avoid them from recurring, plan should perform annual reviews and ensure that the person in charge of determining compensation is properly trained to understand the plan document.
Have questions? Need assistance or guidance? Or want to have an annual review performed on your plan? Please don’t hesitate to call or e-mail Mizan Rahman or Steve Wilkinson.