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Understanding 401(k) Compensation

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What is 401(k) compensation?

401(k) compensation refers to the earnings considered when determining participant deferrals, employer contributions, and compliance testing within a 401(k) plan. Accurately defining compensation is crucial for plan compliance and avoiding IRS correction filings.

Compensation prior to entry is default. Other options are available to plans on the Pro or Flagship level.

Why is the definition of compensation important?

The definition of compensation affects:

  • Participant Elective Deferrals: Determines the portion of earnings participants can defer.
  • Employer Contributions: Impacts matching or profit-sharing amounts.
  • Nondiscrimination Testing: Ensures the plan doesn't favor highly compensated employees (HCEs).
  • Identifying HCEs: Helps in compliance testing and plan fairness.

Using incorrect definitions can lead to compliance issues and IRS correction filings.

What are the safe harbor definitions of compensation?

The IRS outlines three safe harbor definitions under IRC Section 415(c)(3):

  1. W-2 Definition: Wages reported in Box 1 of the W-2, plus taxable portions of certain insurance premiums and fringe benefits.
  2. 3401(a) Definition: Wages subject to federal income tax withholding, plus taxable fringe benefits.
  3. 415 Definition: Includes wages, salaries, bonuses, commissions, taxable medical or disability benefits, and other taxable reimbursements.

Each of these definitions must include pre-tax elective deferrals, such as traditional 401(k) contributions or pre-tax health and welfare benefits, when determining compensation. For example, if an employee earns $50,000 and defers $5,000 into their 401(k), their taxable wages may show as $45,000, but for 401(k) purposes, their compensation is still considered $50,000 under these safe harbor definitions.

How does compensation affect nondiscrimination testing?

Under IRC Section 414(s), the compensation definition is used for nondiscrimination tests like the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. Plans may exclude certain fringe benefits from this definition, but such exclusions must be clearly stated in the plan document and may require additional testing to ensure non-highly compensated employees aren't disproportionately affected.

Can compensation definitions exclude certain earnings?

Yes, plans can exclude specific earnings, such as:

  • Compensation Prior to Entry: Earnings before an employee becomes eligible for the plan.
  • Post-Severance Compensation: Compensation paid after employment ends, which may include bonuses, accrued paid time off, or other earnings, depending on specific conditions and company policies.

These exclusions must be detailed in the plan document and comply with IRS regulations. Note that these exclusions can complicate the administration of the plan. Exclusions to compensation are only available to Pro and Flagship level plans.

Is severance pay included in 401(k) compensation?

Severance pay is compensation provided to an employee when their employment ends, typically due to layoffs, company restructuring, or mutual agreements. It may include a lump sum payment, continued salary for a set period, benefits extensions, or other financial incentives. Severance pay is not considered eligible compensation for 401(k) contributions.