Problem #3 (cont): Maximum compensation limit

A common compensation error in 401(k) plans is not applying the maximum compensation limit of IRC401(a)(17). Of course, there is no limit on the compensation that can be paid to an employee, but thereis a limit on the amount of compensation that can be considered for 401(k) purposes. At no time can a qualified 401(k) plan consider more in compensation than the IRC 401(a)(17) limit. The IRC 401(a)(17) limit is increased with inflation, but for both 2010 and 2011, the maximum compensation limit is$245,000.

This error seems to happen most commonly on 401(k) deferrals and employer matching contributions.If an employee elects to defer 2% of compensation in 2011, then compensation is the 401(k) plan’s definition of compensation for 401(k) deferral purposes limited to $245,000. So, the correct deferral is $4,900 (2% * $245,000), even if the employee’s total compensation without regard to the limit is$2,000,000.

There is often a similar issue with respect to employer matching contributions. The matching contribution must be based upon the 401(k) plan’s definition of compensation limited to $245,000 (for2010 and 2011). Some payroll systems do not seem to easily support the maximum compensation limit, or the payroll person does not know how to set up the maximum compensation limit within the payroll system. If the maximum compensation limit cannot be programmed in the payroll system, it is necessary to have a system in place to manually monitor the limit.

The failure to apply the maximum compensation limit is often caught after the end of the year when the 401(k) TPA or 401(k) provider reviews the employee census. This error often affects the

business owner and/or company executives, and thus any required corrections are extremely sensitive. A typical correction is for the excess contributions to be forfeited from the affected employee’s account.