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Definition of Compensation in a 401 (k) Plan

“What is the definition of compensation used in a 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • Generally speaking, there are several definitions of compensation that may come into play for the purposes of administering qualified retirement plans, such as 401(k) plans. The definition can vary depending on the purpose for its application [e.g., nondiscrimination testing, annual additions testing, maximum deductible contribution, etc.].
  • Ultimately, plan administrators must carefully read the plan document, and follow the definition(s) of compensation as specified therein for the unique purpose.
  • Take nondiscrimination testing, for example. A plan must use a definition of compensation that satisfies Internal Revenue Code Section (IRC §) 414(s) in determining whether the plan has satisfied the nondiscrimination rules [e.g., actual deferral percentage (ADP) and actual contribution percentage (ACP) testing]. There are several definitions of compensation that qualify as IRC §414(s) compensation:
  1. The statutory definition of Treas. Reg. §1.415(c)-2(a)–2(c) (a.k.a., “415 compensation”)
  2. The simplified definition, which is defined at Treas. Reg. §1.415(c)-2(d)(2)
  3. W-2 wages, which is defined at Treas. Reg. §1.415(c)-2(d)(4)
  4. Wages for income tax withholding under IRC §3401(a), defined at Treas. Reg. §1.415(c)-2(d)(3)
  5. One of the above definitions with certain adjustments
  6. Any reasonable definition of compensation that does not favor highly compensated employees
  • The IRS has a helpful comparison table that illustrates what items of pay (e.g., nonstatutory stock options or tips) are included or excluded under the various definitions of compensation for nondiscrimination purposes.  It is part of “Exhibit B,” found on page 47 of the IRS’ CPE course on Compensation.
  • It warrants repeating that it is essential for plan administrators to understand 1) the particular plan purpose for which a definition of compensation is needed, 2) how the plan document defines compensation for that particular purpose, and 3) how to accurately apply the definition.
  • Failure to follow the correct definition of compensation for a plan is an operational failure that could affect its qualified status if not properly corrected.  The IRS has suggestions on Avoiding Compensation Errors in Retirement Plans and how to correct them if they occur.

 

Conclusion

Several definitions of compensation may come into play for the purposes of administering qualified retirement plans. It is essential for plan administrators to understand 1) the particular plan purpose for which a definition of compensation is needed, 2) how the plan document defines compensation for that particular purpose, and 3) how to accurately apply the definition.

 

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