In last month’s compliance check, we discussed how to handle a situation where the 401(k) plan administrator is unable to reach a plan participant, i.e. a “missing participant.” . In this month’s compliance check, we focus on defining your 401(k) plan compensation for reporting and matching purposes.
Why is this topic important?
401(k) plan sponsors are required to include a legally compliant definition of “compensation” in the plan document. Compensation is an important element in determining a participant’s deferred contributions to the 401(k) plan and the corresponding amounts of the related company. Failure to include a legally compliant definition of compensation will result in failure of the plan document, and non-adherence to the definition of plan compensation when withholding optional participant deferrals and calculating plan contributions. company counterparty will result in operational failure. Unfortunately, compensation-related failures are common in 401(k) plan administration. These failures can result in the need for time-consuming and costly remediation through the Internal Revenue Service’s Employee Plans Compliance Resolution System (EPCRS) to maintain the tax status of the 401(k) plan.
What are the general definitions of compensation that can be used for 401(k) deferral and matching purposes?
Most 401(k) plans, including Safe Harbor 401(k) plans, use one of the following compensation definitions for reporting and 401(k) matching purposes: (i) a salary amount W -2, plus additional amounts that would be salaries, but for a participant election (e.g., a pre-tax election under the 401(k) plan sponsor’s cafeteria plan and the 401(k) deferral election Participant), (ii) Income Tax Code (Code) Section 3401(a) (i.e., a Participant’s wages subject to withholding, plus additional amounts that would be wages but for a participant’s election), or (iii) a Code Section 415 amount that includes wages, salaries, fees for professional services provided to the 401(k) on plan sponsor, plus additional amounts that would be salaries but for a member’s choice. 401(k) safe harbor plans must use one of the preceding definitions of compensation in order to meet applicable Code requirements to be treated as a safe harbor plan. In addition to one of these definitions, many 401(k) plan sponsors choose to exclude income related to reimbursements or other expense allowances, employee benefits (cash or non-cash), moving expenses, deferred compensation and employee benefits of the definition of compensation. for reporting and correspondence purposes, and these exclusions are deemed to comply with the law.
Are there other definitions of compensation allowed for deferral and 401(k) matching purposes?
Although a 401(k) plan sponsor may have the ability to define compensation in a manner different from that summarized above, it must be done in a manner that does not discriminate in favor of highly compensated employees ( HCE).1 For example, if a plan sponsor defines compensation in such a way as to exclude overtime pay and only non-highly paid participants are eligible for overtime, it is possible that the definition of pay could be considered discriminatory for the purposes of the plan. compliance review and potentially affects the tax status of the plan.
What is the effect of using an incorrect definition of compensation for deferral or 401(k) matching purposes?
If you are not using a compliant definition of compensation in your plan document, or if you are not properly managing the applicable definition of compensation for the purposes of your 401(k) plan deferrals and matches, you will need to make corrections. potentially costly and time-consuming. as part of the IRS EPCRS. These types of compensation errors can arise in a number of ways, including in connection with a plan amendment that changes the definition of compensation, the possibility of checking an incorrect box with respect to a pre-approved plan adoption agreement or simply the failure to properly review the 401(k) plan document before it is signed. Additionally, 401(k)-related compensation errors frequently occur operationally when new pay codes are added by a plan sponsor’s payroll department without coordination with the 401(k) team to ensure that an element of remuneration is correctly included or excluded from the plan. for carry-over and match purposes.
The general rule for shot corrections is that participants should be placed in the position they would have been in but for the error. In many cases, corrections related to compensation errors can be made through the EPCRS Self-Correction Procedure (SCP), but other larger errors or errors occurring over a longer period of time may mean that the IRS Voluntary Correction Procedure (VCP) must be used. When the VCP is required, the company must file the correction with the IRS and pay a filing fee, in addition to remitting the corrective contributions that must actually be made to the plan to correct the error. It is important to note that retroactive changes can be used even under the SCP if the corrective change results in an increase in 401(k) deferrals or matching contributions from affected participants. In summary, 401(k) plan sponsors are much better off ensuring that their plan is administered in a manner that uses a consistent definition of compensation.
What are best practices for maintaining compliance with the definition of 401(k) plan compensation?
While there is no one size fits all, 401(k) plan sponsors should consider doing the following to stay compliant with the definition of 401(k) plan compensation:
periodically review or audit their plan’s compensation definition to ensure that the correct compensation amounts are being used for reporting and 401(k) matching purposes;
any periodic compensation review or audit must include an audit of all amounts specifically designated as included or excluded in the applicable plan document;
random compliance testing of participants’ individual accounts should be performed;
communications between the payroll and human resources departments of the 401(k) sponsor should be continuously monitored to ensure that the two departments are aligned for purposes of defining 401(k) participant compensation;
401(k) tests should always be repeated when new pay codes are introduced to avoid operational errors related to plan compensation definition; and
401(k) plan sponsors should consider seeking the advice of an outside advisor, if necessary, to make necessary, IRS-compliant corrections regarding compensation errors.
1 For HCE 2022 status, the 2021 pay threshold was $130,000 and for HCE 2023 status, the 2022 pay threshold is $135,000.