In our first article, we discussed the general rules and principles surrounding qualified retirement plan operational failures. This article will discuss plan compensation and the importance of following the definition in the plan document to avoid operational failures.

If asked, most employees can tell you how much money they make doing their job. Generally, they will quote an annual salary or an hourly pay rate. If you ask the same employees what their compensation is, many will provide the same answer but a few may add in bonuses or other sources of pay from their employer. Some may refer to it as pay or wages while others refer to it as salary or income. According to the Code of Federal Regulations, the term compensation means any form of payment made to an individual for services rendered as an employee for an employer. So, whether you call it wages, income, pay, or salary, it is all considered compensation to Uncle Sam.

Compensation is important to the IRS for many reasons, but this article focuses on compensation specific to qualified retirement plans. Compensation is a critical element in providing retirement benefits for all types of qualified retirement plans, including 401(k) plans, pension plans, and Employee Stock Ownership Plans (ESOPs). It is used to determine which employees are considered highly compensated or key for nondiscrimination testing and is also used as the basis for determining plan contributions and, ultimately, retirement benefits.

While compensation may mean different things to different people, the IRS requires the plan document to specify what is considered compensation for plan purposes. The definition included in the plan document is very precise, and compensation must be determined exactly as the plan says to avoid errors or operational failures.

The three most common definitions for the basis of plan compensation are:

• W-2 wages
• Internal Revenue Code (IRC) section 3401(a) wages
• IRC section 415 safe harbor compensation

Each definition is slightly different, and it is important to understand the differences when deciding which is best for your plan. Below is a basic overview of these three definitions.

W-2 wages are a popular choice because they are already reported annually to the IRS. These wages include all pay to the employee associated with employment that are taxable. In addition to base salary, it also includes bonuses, commissions, tips, overtime, taxable fringe benefits, and any other taxable payments related to employment. It is important to note that other taxable payments may include imputed income that is credited to an employee but not physically paid. One common example of this type of compensation is the cost of group life insurance that is in excess of $50,000.

IRC section 3401(a) wages are defined as wages subject to withholding of federal income tax at the source of payment. It is commonly referred to as “paystub” compensation because it directly impacts an employee’s “take home” pay. While it is similar to W-2 wages, it only includes cash payments; it does not include imputed income. Using the same example above, the cost of group insurance that is in excess of $50,000 would not be considered as compensation under this definition.

IRC section 415 safe harbor compensation includes all pay includable in gross income, without regard to whether it is paid in cash for personal services rendered while employed with the plan sponsor. This definition excludes certain compensation related to employer contributions not includable in the employee’s gross income for the year in which contributed. It also excludes income related to the sale of stock associated with certain stock option plans and other amounts that receive special tax benefits.

A basic understanding of the types of compensation that may be defined in a preapproved retirement plan is crucial to calculating what compensation is considered eligible for retirement plan purposes. It is important to note that the IRS allows plans to modify these definitions by including certain taxable and nontaxable pay.

Examples of nontaxable income included in the definition of plan compensation:

• Pretax deferrals made to a qualified retirement plan, e.g., 401(k), 403(b), 457
• Pretax contributions made to a section 125 welfare benefit plan

Examples of taxable income excluded from plan compensation:

• Taxable fringe benefits and/or reimbursements
• Compensation earned prior to the plan entry date
• Military wage differential
• Commissions
• Bonuses
• Overtime

These are only a few examples of the modifications allowed. Regardless of the definition of compensation the plan uses, the definition cannot favor highly compensated employees and may require additional testing to prove that it is not discriminatory.

Plan sponsors should work closely with their payroll service providers or their Human Resource Information System (HRIS) or payroll software providers to ensure the correct compensation components are included for plan compensation. It is important to consider the impact on plan compensation when modifications to the payroll or HRIS systems are made, including adding or removing pay codes.

For example, over the last few years, many employers added COVID-19 pay components to their payroll systems, but not all remembered to update their deferral and match calculations to include this pay. Unless this compensation is explicitly excluded from the definition of compensation in the plan document, it should be considered for plan purposes.

Plan sponsors should periodically verify that the correct definition of compensation is being used for the plan to avoid operational failures related to compensation. If the correct plan compensation is not used, it is likely that plan contributions, both employee and employer, are not correct either. The IRS considers this type of error as an operational failure because the terms of the plan have not been followed. Operational failures must be corrected, and all affected plan participant accounts made whole. This could require a qualified nonelective contribution (QNEC) and, if applicable, missed matching contributions.

The IRS offers a couple of different correction programs that plan sponsors can use to correct operational errors through the Employee Plan Compliance Resolution System (EPCRS). The severity of the error along with other facts and circumstance will help determine which correction program should be used. If you have concerns about this or other operational errors in your plan, contact your Milliman relationship manager or a Milliman compliance consultant to discuss your plan specifics.

Compensation Definition in Safe Harbor 401(k) Plans | Internal Revenue Service (irs.gov)