How to Navigate the Compensation Options in 401(k) Plans

With the IRS's release of the 2017 401(k) contribution limits and the annual compensation cap for calculating deferral and matching contributions, plan sponsors may want to revisit how their plan documents define "compensation"—and how that definition (or definitions) affects employee participation and savings rates.

Sponsors of 401(k) plans have some leeway in selecting which kinds of employee compensation to use for determining employee-deferral and employer-matching contributions, said Martha M. Sadler, executive vice president at Newport Group, a retirement plan and executive benefits consultancy in New Bern, N.C.

"Internal Revenue Code [IRC] section 415 provides three alternative definitions of compensation in qualified retirement plans," said Sadler, who spoke on Oct. 23 at the annual conference of the American Society of Pension Professionals & Actuaries (ASPPA) in National Harbor, Md. Those options are:

• Form W-2, Box 1 wages—Wages, tips and other compensation subject to federal tax withholding.
  
• Section 3401(k) wage—Same as W-2 but with certain exclusions such as the taxable cost of group-term life insurance.
  
• Section 415 safe harbor or "simplified" compensation—All compensation received from the employer that can be included in gross income.
  

"Plan documents must provide the specific definition of compensation" for specific purposes, Sadler said. In addition, IRC section 414(s) requires that a nondiscriminatory definition of compensation be used when performing annual nondiscrimination tests—the actual deferral percentage (ADP) test and actual contribution percentage (ACP) test that a qualified retirement plan must satisfy.

Common adjustments to compensation include:

• Excluding bonuses.
  
• Excluding commissions.
  
• Excluding overtime.
  
• Excluding shift differentials.
  

But exercise caution because "non-safe harbor compensation adjustments may turn out to be discriminatory" by impermissibly favoring highly compensated employees and should be tested for compliance with nondiscrimination tests, Sadler said.

[SHRM members-only toolkit: Designing and Administering Defined Contribution Retirement Plans]

Beware the Pitfalls

Practices that can complicate nondiscrimination tests include:

• Using different definitions of compensation for employee deferral and employer matches, for instance, by excluding incentive pay from match calculations.
  
  
• Applying different vesting periods for employee deferrals (e.g., immediate eligibility), employer matching (e.g., six months of service) and employer nonelective profit-sharing contributions (e.g., one year of service).
  

Common compensation errors, she noted, include:

• A plan defines compensation as Form W-2 wages for elective deferrals but fails to withhold 401(k) deferrals from employees' bonuses.
  
  
• A plan defines compensation as Form W-2 wages for elective deferrals excluding monetary benefits, but deferrals are based on gross compensation including benefits.

"Mistakes found early are usually cheaper to correct," she added.

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