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Understanding 401(k) Compensation

Using an incorrect definition of compensation is on the top ten list of mistakes the IRS sees in voluntary correction filings.

By Betterment Editors

Published Sep. 30, 2020 | Updated Sep. 22, 2022

Understanding 401(k) Compensation Sep 22, 2022 2:27:00 PM Using an incorrect definition of compensation is on the top ten list of mistakes the IRS sees in voluntary correction filings. Compensation is used to determine various elements of any 401(k) plan including: Participant elective deferrals Employer contributions Whether the plan satisfies certain nondiscrimination requirements Highly compensated employees (HCEs) for testing purposes The IRS permits a plan to use multiple definitions of compensation for different purposes, but there are rules surrounding which definition can be used when. This is why using an incorrect definition of compensation is on the top ten list of mistakes the IRS sees in voluntary correction filings. General Definition of Plan Compensation There are three safe harbor definitions outlined in IRC Section 415(c)(3) that can be used to define “plan compensation” used to allocate participant contributions. W-2 Definition—Wages reported in box 1 of W2 PLUS the taxable portion of certain insurance premiums and taxable fringe benefits. The 3401(a) Definition–Wages subject to federal income tax withholding at the source PLUS taxable fringe benefits. The 415 Definition–Wages, salaries, and other amounts received for services rendered such as bonuses, and commissions. It also includes items such as taxable medical or disability benefits and other taxable reimbursements. In some contexts, the plan is required to use this definition for purposes of determining HCEs and the maximum permissible contributions. For all of these definitions, pre-tax elective deferrals are included in reported compensation. In addition, it’s important to note the annual cost of living adjustments on compensation as well as contribution limits by the IRS. These will impact the amount of allowable employer and employee contributions. Compensation for Non-Discrimination Testing As defined in IRC Section 414(s), this definition of compensation is primarily used for various nondiscrimination tests. Safe harbor match or safe harbor nonelective plans, for example, must use this definition to bypass the actual deferral percentage (ADP) and the actual contribution percentage (ACP) test. Each of the three 415(c)(3) definitions also satisfy the 414(s) compensation definition of compensation and can be used for non-discrimination testing. However, a 414(s) definition of compensation can include certain modifications that are not permissible where a 415(c)(3) definition is required. It is not uncommon for the 414(s) definition to exclude fringe benefits such as personal use of a company car or moving expenses. Exclusions of certain forms of pay must be clearly stated and identified in the plan document but may trigger additional nondiscrimination testing (known as compensation ratio testing) to make sure non-highly compensated employees are not disproportionately affected. Additional Compensation Definitions Pre-entry or pre-participation Compensation Plans that have a waiting or eligibility period may elect to exclude compensation earned prior to entering the plan from the compensation definition. This may help alleviate some of the financial burden associated with an employer match or profit-sharing contribution. Although such an exclusion would not trigger any compensation discrimination test, a plan that is deemed “top-heavy” (more than 60% of assets belong to key employees) must calculate any required employer contribution using the full year’s worth of compensation. Post-severance Compensation Post severance compensation are amounts that an employee would have been entitled to receive had they remained employed. It usually includes amounts earned but not yet paid at time of termination (bonuses, commissions), payments for unused leave such as vacations or sick days, and any distributions made from a qualified retirement plan. To be considered as post-severance pay eligible and included in the definition of plan compensation, amounts must be paid before the later of the last day of the plan year in which the employee terminated or two and a half months following the date of termination. Taxable Fringe Benefits Non-cash items of value given to the employee, such as the use of a company car for personal use, must be reported as taxable income. A plan can exclude taxable fringe benefits from its compensation definition and therefore not be subject to the compensation ratio test. Bonuses, Commissions, and Overtime These types of payments are considered plan compensation unless specifically excluded in the plan document. Many employers decide to exclude them because they are not regularly recurring, but should be aware that such exclusions will trigger the compensation ratio test. However, such exclusions must be specifically detailed in the plan document. For example, If a company offers a performance bonus, hiring bonus, and holiday bonus but decides to exclude the hiring and holiday bonuses from the definition of plan compensation, then it must be specific, since “bonus” would be too broad and include all types. Reimbursements and Allowances Allowances (amounts received without required documentation) are taxable, while reimbursements for documented and eligible expenses are not taxable. Allowances are therefore included in the definition of plan compensation while reimbursements are not. An allowance is generally considered a taxable fringe benefit so it is reported and follows certain rules above in regards to compensation definitions. International Compensation Tax implications can easily rise when dealing with international workers and compensation. Employers with foreign affiliates that sponsor non-US retirement plans still may be subject to the US withholding and reporting requirements under the Foreign Account Tax Compliance Act (FATCA) to combat tax evasions. Companies with employees who either work outside of the U.S. or who work in the U.S. with certain visas will need to carefully review each employee’s status and 401(k) eligibility. Rules and requirements vary by country. However, when 401(k) eligibility is based on citizenship or visa status, work location and compensation currency is not a factor. Define Plan Compensation Carefully Payroll is often a company’s largest expense, so it’s no surprise that companies devote significant time and energy to develop their compensation strategies. However, companies need to be mindful of the implications of their compensation program. Even simple pay structures do not necessarily translate into simple 401(k) plan definitions of compensation. It’s important to review the plan document carefully to be sure compensation definitions used reflect the desires of the company, that the definitions chosen are accurately applied, and that implications are clearly understood. Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.

Compensation is used to determine various elements of any 401(k) plan including:

Participant elective deferrals
Employer contributions
Whether the plan satisfies certain nondiscrimination requirements
Highly compensated employees (HCEs) for testing purposes

The IRS permits a plan to use multiple definitions of compensation for different purposes, but there are rules surrounding which definition can be used when. This is why using an incorrect definition of compensation is on the top ten list of mistakes the IRS sees in voluntary correction filings.

General Definition of Plan Compensation

There are three safe harbor definitions outlined in IRC Section 415(c)(3) that can be used to define “plan compensation” used to allocate participant contributions.

W-2 Definition—Wages reported in box 1 of W2 PLUS the taxable portion of certain insurance premiums and taxable fringe benefits.
The 3401(a) Definition–Wages subject to federal income tax withholding at the source PLUS taxable fringe benefits.
The 415 Definition–Wages, salaries, and other amounts received for services rendered such as bonuses, and commissions. It also includes items such as taxable medical or disability benefits and other taxable reimbursements.

In some contexts, the plan is required to use this definition for purposes of determining HCEs and the maximum permissible contributions.

For all of these definitions, pre-tax elective deferrals are included in reported compensation. In addition, it’s important to note the annual cost of living adjustments on compensation as well as contribution limits by the IRS. These will impact the amount of allowable employer and employee contributions.

Compensation for Non-Discrimination Testing

As defined in IRC Section 414(s), this definition of compensation is primarily used for various nondiscrimination tests. Safe harbor match or safe harbor nonelective plans, for example, must use this definition to bypass the actual deferral percentage (ADP) and the actual contribution percentage (ACP) test.

Each of the three 415(c)(3) definitions also satisfy the 414(s) compensation definition of compensation and can be used for non-discrimination testing. However, a 414(s) definition of compensation can include certain modifications that are not permissible where a 415(c)(3) definition is required. It is not uncommon for the 414(s) definition to exclude fringe benefits such as personal use of a company car or moving expenses.

Exclusions of certain forms of pay must be clearly stated and identified in the plan document but may trigger additional nondiscrimination testing (known as compensation ratio testing) to make sure non-highly compensated employees are not disproportionately affected.

Additional Compensation Definitions

Pre-entry or pre-participation Compensation

Plans that have a waiting or eligibility period may elect to exclude compensation earned prior to entering the plan from the compensation definition. This may help alleviate some of the financial burden associated with an employer match or profit-sharing contribution. Although such an exclusion would not trigger any compensation discrimination test, a plan that is deemed “top-heavy” (more than 60% of assets belong to key employees) must calculate any required employer contribution using the full year’s worth of compensation.

Post-severance Compensation

Post severance compensation are amounts that an employee would have been entitled to receive had they remained employed. It usually includes amounts earned but not yet paid at time of termination (bonuses, commissions), payments for unused leave such as vacations or sick days, and any distributions made from a qualified retirement plan. To be considered as post-severance pay eligible and included in the definition of plan compensation, amounts must be paid before the later of the last day of the plan year in which the employee terminated or two and a half months following the date of termination.

Taxable Fringe Benefits

Non-cash items of value given to the employee, such as the use of a company car for personal use, must be reported as taxable income. A plan can exclude taxable fringe benefits from its compensation definition and therefore not be subject to the compensation ratio test.

Bonuses, Commissions, and Overtime

These types of payments are considered plan compensation unless specifically excluded in the plan document. Many employers decide to exclude them because they are not regularly recurring, but should be aware that such exclusions will trigger the compensation ratio test.

However, such exclusions must be specifically detailed in the plan document. For example,

If a company offers a performance bonus, hiring bonus, and holiday bonus but decides to exclude the hiring and holiday bonuses from the definition of plan compensation, then it must be specific, since “bonus” would be too broad and include all types.

Reimbursements and Allowances

Allowances (amounts received without required documentation) are taxable, while reimbursements for documented and eligible expenses are not taxable. Allowances are therefore included in the definition of plan compensation while reimbursements are not. An allowance is generally considered a taxable fringe benefit so it is reported and follows certain rules above in regards to compensation definitions.

International Compensation

Tax implications can easily rise when dealing with international workers and compensation. Employers with foreign affiliates that sponsor non-US retirement plans still may be subject to the US withholding and reporting requirements under the Foreign Account Tax Compliance Act (FATCA) to combat tax evasions.

Companies with employees who either work outside of the U.S. or who work in the U.S. with certain visas will need to carefully review each employee’s status and 401(k) eligibility. Rules and requirements vary by country. However, when 401(k) eligibility is based on citizenship or visa status, work location and compensation currency is not a factor.

Define Plan Compensation Carefully

Payroll is often a company’s largest expense, so it’s no surprise that companies devote significant time and energy to develop their compensation strategies. However, companies need to be mindful of the implications of their compensation program. Even simple pay structures do not necessarily translate into simple 401(k) plan definitions of compensation. It’s important to review the plan document carefully to be sure compensation definitions used reflect the desires of the company, that the definitions chosen are accurately applied, and that implications are clearly understood.

Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.