At face value, it seems like “compensation” would be one of the simplest issues to deal with in a retirement plan, but it is actually one of the most complex. Understanding what compensation is “plan eligible” is one of the biggest headaches for plan sponsors and an area in which plan sponsors often make mistakes.
If you think about all the different forms of compensation you pay your employees (e.g. bonuses, commissions, fringe benefits, paid sick time, vacation time, automobile allowance, severance pay, group term life in excess of $50,000, etc.), it becomes clear why this is such a complex issue!
What is “plan eligible” compensation?
Plan eligible compensation must be defined under the terms of the plan, and the terms of the plan must be followed. There are 3 basic definitions of compensation that are commonly used:
- W-2 Compensation
- Income subject to federal income tax withholding
- “415” Compensation (basically, an all-encompassing definition)
Note: Other definitions of compensation may be used, but they are generally subject to additional testing requirements.
Why does plan compensation matter?
It matters for several reasons, but primarily because all contributions must be based on the plan’s definition of compensation.
What is this important to me as a plan sponsor?
At the end of the day, a plan must be operated in accordance with the terms of the plan to protect its qualified status, so it is very important to understand what compensation is plan eligible.
Common sense often drives employers to make decisions about whether to apply an employee’s 401(k)/Roth election to certain compensation items, but common sense doesn’t rule in this situation.
For example, one of the most common mistakes made by plan sponsors is to not withhold employee deferrals from bonuses, rather than allowing employees to make this election.
Bonuses are plan compensation, unless specifically excluded under the terms of the plan. Unless the plan allows employees to make a specific election with respect to bonuses, the deferral election must be applied to this compensation.
So, what happens if an employer makes a decision not to withhold from bonuses? Generally, the correction is for the employer to make a corrective contribution on behalf of the affected participants for the “missed deferral” along with any related matching contributions, adjusted for earnings. A mistake that is costly for the employer and totally preventable!
Can a plan exclude bonuses or commissions from its definition of compensation?
It depends; unless the plan uses one of the “common” definitions, certain testing must be done each plan year to ensure the plan’s definition of compensation doesn’t discriminate in favor of the plan’s highly compensated employees. Excluding bonuses or commissions from eligible compensation requires this additional testing, so whether it is viable in a given situation depends on a number of factors.
What about fringe benefits; must they be included?
No, provided the plan’s definition excludes all of the following (even if includible in gross income): reimbursements or other expense allowances, fringe benefits (cash and noncash), moving expenses, deferred compensation, and welfare benefits.
Can we exclude other compensation items from the plan’s definition of compensation?
It depends on your specific company, how you compensate your employees, the demographics or your workforce and the general provisions of your plan. It is certainly acceptable to design your plan in such a way that certain compensation items are excluded provided the plan can meet the necessary nondiscrimination testing requirements and you can properly administer its provisions.
The Bottom Line
A plan’s definition of compensation is one of the most complex issues impacting retirement plans. It is important your plan is designed properly to meet your specific needs and that you, as a plan sponsor, understand your plan’s definition of compensation so that you can keep your plan in compliance and avoid costly mistakes!
We possess the necessary expertise to help you navigate through these issues and want to help you optimize your plan’s design so that it works well for you and your employees! Please contact us to learn more.