“What definition of compensation does a 401(k) plan use in plan administration?”
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, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
A recent call with a financial advisor from Washington D.C. is representative of a common inquiry related to the definition of compensation for plan purposes.
Highlights of the Discussion
The term “compensation” has several different applications in qualified retirement plan operations, depending on the particular compliance goal. For example, a plan may use one definition of compensation to allocate employer contributions and a separate, distinct one for testing whether employee salary deferrals are nondiscriminatory. One of the top plan compliance concerns identified by the IRS is a plan sponsor’s failure to identify and apply the correct definition of compensation in a particular scenario. What follows is a general description of the various definitions of compensation that plan sponsors are required or permitted to use for various plan purposes.
The definitions of compensation used for the plan must be specified in the governing plan documents. Plan documents that are preapproved by the IRS simplify the process of selecting the various definitions of compensation. Plan sponsors are, ultimately, responsible for making sure the party administering the plan (e.g., CPA, record keeper, or third-party administrator) is using the appropriate definition of compensation.
At a high level, there are two primary definitions of plan compensation from the Internal Revenue Code (IRC) that apply in plan operations, one is found in IRC Sec. 415(c)(3) and the other is in IRC Sec. 414(s). Other IRC sections and regulations refer to one or the other of these definitions, and specify which of the compensation definitions a plan can or must use for a particular purpose.
IRC Sec. 415(c)(3) compensation
There are four different definitions of compensation in the regulations under IRC Sec. 415(c)(3) from which a plan sponsor may choose: 1) statutory; 2) simplified; 3) W-2; or 4) 3401 withholding wages. Please refer to the chart on pages 47-48 of the IRS’s material on Compensation for a comparison of the definitions.
A plan must use an IRC Sec. 415(c) definition of compensation when determining the following:
- Annual limits on contributions and benefits;
- Which employees are highly compensated employees and key employees;
- A top-heavy minimum contribution, when needed;
- The minimum “gateway” contribution for plans using a cross-tested contribution allocation method; and
- A sponsor’s maximum tax deductible contribution for a year.
IRC Sec. 414(s) compensation
With respect to IRC. Sec. 414(s) compensation, any definition of compensation that satisfies IRC Sec. 415(c)(3) will automatically satisfy IRC Sec. 414(s). In addition, the regulations under IRC Sec. 414(s) also provide for a safe harbor alternative definition. Under the alternative safe harbor, a plan starts with a definition of compensation that satisfies IRC Sec. 415(c)(3), and reduces it by all of the following categories of compensation:
- Reimbursements or other expense allowances;
- Cash and noncash fringe benefits;
- Moving expenses;
- Deferred compensation; and
- Welfare benefits.
A plan must use a definition of compensation that meets the requirements of IRC Sec. 414(s) when determining the following:
- Contributions for a design-based safe harbor plan or a safe harbor 401(k) plan;
- A participant’s actual deferral ratio and actual contribution ratio used in performing the actual deferral percentage (ADP) and actual contribution percentage (ACP) nondiscrimination tests in a 401(k) plan;
- Whether contributions and benefits are nondiscriminatory under Sec. 401(a)(4) (other than the minimum contribution component of the gateway test mentioned previously);
- Contributions under a design-based safe harbor plan with permitted disparity provisions.
Finally, a sponsor has some leeway in choosing a definition of compensation, provided it is reasonable and does not unduly favor highly compensated employees, when determining the following:
- Contributions (if the plan is not a design-based safe harbor);
- The maximum permitted deferrals within a 401(k) plan; and
- The plan sponsor’s matching contributions for participants.
Applying the proper definition of plan compensation for a particular compliance purpose is one of the trickiest parts of administering a plan correctly. Sponsors and their CPAs, record keepers, and/or TPAs must always refer to the plan document for the correct definition of compensation to apply based on the function being performed.
 A design-based safe harbor plan is designed to demonstrate nondiscrimination with a uniform method of allocating contributions.
 Allocation formula integrated with Social Security