In last month’s Compliance Check, we discussed how to handle a situation where the 401(k) plan administrator is unable to reach a plan participant, i.e., a “missing participant.” In this month’s Compliance Check, we focus on your 401(k) plan’s compensation definition for deferral and match purposes.
Why is This Topic Important?
401(k) plan sponsors are required to include a legally compliant definition of “compensation” within the plan document. Compensation is a material component in determining a 401(k) plan participant’s deferral contributions and related company match amounts. Failure to include a legally compliant definition of compensation will result in a plan document failure, and the failure to follow the plan’s definition of compensation when withholding participant elective deferrals and calculating company matching contributions will result in an operational failure. Unfortunately, compensation-related failures are common occurrences in connection with 401(k) plan administration. These failures may result in time-consuming and expensive corrections being required through the Internal Revenue Service’s Employee Plans Compliance Resolution System (EPCRS) to maintain the 401(k) plan’s tax-qualified status.
What are the General Definitions of Compensation that May be Used for 401(k) Deferral and Match Calculation Purposes?
Most 401(k) plans, including safe harbor 401(k) plans, use one of the following compensation definitions for 401(k) deferral and match purposes: (i) a W-2 wages’ amount, plus additional amounts that would be wages but for a participant election (e.g., a pre-tax election under the 401(k) plan sponsor’s cafeteria plan and the participant’s 401(k) deferral election), (ii) Internal Revenue Code (Code) Section 3401(a) wages (i.e., a participant’s wages subject to withholding at the source, plus additional amounts that would be wages but for a participant election), or (iii) a Code Section 415 amount that includes wages, salaries, fees for professional services provided to the 401(k) plan sponsor, plus additional amounts that would be wages but for a participant’s election. 401(k) safe harbor plans must use one of the preceding compensation definitions in order to satisfy applicable Code requirements to be treated as a safe harbor plan. In addition to one of these definitions, many 401(k) plan sponsors choose to exclude income related to reimbursements or other expense allowances, fringe benefits (cash or non-cash), moving expenses, deferred compensation and welfare benefits from the definition of compensation for deferral and match purposes, and these exclusions are considered legally compliant.
Are there Other Compensation Definitions Permitted for 401(k) Deferral and Match Purposes?
Although a 401(k) plan sponsor may have the ability to define compensation in a different manner than summarized above, it must be done in a manner that does not discriminate in favor of highly compensated employees (HCEs).1 For example, if a plan sponsor defines compensation to exclude overtime pay and only non-highly compensated participants are eligible for overtime, then it is possible that the compensation definition will be considered discriminatory for testing compliance purposes and potentially affect the tax-qualified status of the plan.
What is the Effect of Using an Incorrect Definition of Compensation for 401(k) Deferral or Match Calculation Purposes?
A failure to use a compliant definition of compensation in your plan document, or a failure to administer properly the applicable compensation definition for purposes of your 401(k) plan’s deferrals and matches, will result in having to make potentially expensive and time‑consuming corrections under the IRS’ EPCRS. These types of errors related to compensation may occur in a number of ways including in connection with a plan amendment that changes the definition of compensation, possible incorrect checking of a box with respect to a pre-approved plan adoption agreement, or just a failure to properly review the 401(k) plan document before it was signed. In addition, 401(k)-related compensation errors frequently occur operationally when new payroll codes are added by a plan sponsor’s payroll department without coordinating with the 401(k) team to insure that an item of compensation is properly being included or excluded for plan deferral and match purposes.
The general rule for plan corrections is that participants should be placed in the position they would have been in but for the error. In many cases, corrections related to compensation errors may be completed through EPCRS’ self-correction procedure (SCP), but other, more significant errors or errors occurring over a longer period of time, may mean that the IRS’s voluntary correction procedure (VCP) must be used. When VCP is required, the company must file the correction with the IRS and pay a filing fee, in addition to making any corrective contributions actually required to be made to the plan to correct the error. Importantly, retroactive amendments may be used even under SCP if the corrective amendment results in an increase to affected participants’ 401(k) deferrals or matching contributions. In summary, 401(k) plan sponsors are much better off making sure that their plan is being administered in a manner that uses a compliant definition of compensation.
What are the Best Practices for Maintaining Compliance with the 401(k) Plan’s Definition of Compensation?
Although not one size fits all, 401(k) plan sponsors should consider doing the following to maintain compliance with the 401(k) plan’s definition of compensation:
periodically review or audit their plan’s compensation definition to make sure that the correct compensation amounts are being used for 401(k) deferral and match purposes;
any periodic compensation review or audit should include a check of any amounts specifically designated as included or excluded under the applicable plan document;
random testing of individual participant accounts for compliance should be conducted;
communications between the 401(k) sponsor’s payroll and human resources’ departments should constantly be monitored to make sure both departments are aligned for 401(k) participant compensation definition purposes;
401(k) testing always should be repeated when new payroll codes are introduced in order to prevent operational errors in connection with the plan’s compensation definition; and
401(k) plan sponsors should consider seeking outside advisor advice, if needed, in order to make any necessary and IRS-compliant corrections relating to compensation errors.
1 For 2022 HCE status, the 2021 compensation threshold was $130,000 and for 2023 HCE status the 2022 compensation threshold is $135,000.