Problem #3 Incorrect Definition of Compensation

The third error identified in the IRS 401(k) Fix-It Guide is using the incorrect definition of compensation. Every 401(k) plan document defines compensation for 401(k) purposes, and in some cases the 401(k) plan document defines multiple definitions of compensation for different purposes. For example, a plan document may define compensation for 401(k) deferrals one way and use a different definition of compensation for profit sharing purposes.

  • 401(k) Deferral Compensation – Plan documents define the compensation for 401(k) deferrals. So, if a participant signs an election form indicating that the participant wants to defer 5% of compensation, the question is 5% of what compensation? Base compensation? Total compensation? The plan document answers this question. A common error that employers make in this area is with regard to bonuses. The plan document will say to withhold 401(k) deferrals from bonuses, but when the bonus payroll is run, no deferrals are taken from the bonus.
  • Matching Compensation – The plan document may define a different definition of compensation for employer matching contributions. Many employers calculate their employer match in the payroll system as an informational item. When setting up this calculation in the payroll system, the employer must ensure that the payroll system’s definition of compensation for this calculation matches the 401(k) plan document. For example, if the plan document says total compensation, the matching calculation should be based on total compensation.
  • Profit Sharing Compensation – A 401(k) plan document may also define a different definition of compensation for profit sharing. An error that is common with profit sharing compensation is inappropriately including or excluding pre-entry compensation. In the year that an employee becomes eligible to participate in the 401(k) plan, the plan document will specify whether to include or exclude compensation prior to the date that the employee entered the plan. Sometimes employers will try to apply common sense instead of referring to the plan document.

It is important for employers to be familiar with the definitions of compensation in their 401(k) plan document.