The term compensation is important in the design and operation of a retirement plan. Compensation determines how much the employee and employer can contribute to the plan and also directly affects the results of the plan’s annual nondiscrimination testing. Review your Adoption Agreement to accurately determine how compensation is defined for your plan.
Options to Define Compensation
There are three options to define what types of earnings are considered compensation:
- Section 3401(a) Wages. This is based on what the employee sees on each pay stub. It includes wages plus bonuses and stock options taxable at date of grant and taxable restricted property, but excludes all taxable reimbursements and the cost of group-term life coverage. It also excludes all pre-tax deferrals to 401(k), 403(b) and Section 125 plans, but it can be grossed up to include these amounts.
- W-2 Wages. This includes wages, tips and other compensation as reported on Box 1 of Form W-2. It includes Section 3401(a) wages plus taxable reimbursements and the cost of group-term life coverage. It excludes all pre-tax deferrals to 401(k), 403(b), and Section 125 plans, but it may be grossed up to include these amounts.
- 415 Safe-Harbor Compensation. It is total compensation, plus certain items of income that are not included on Form W-2, such as reimbursed moving and auto expenses, taxable non-qualified stock options, and the cost of group-term life insurance coverage in excess of $50,000. It includes all pre-tax deferrals to 401(k), 403(b) and Section 125 plans.
NOTE: These are not exhaustive descriptions. Consult with Monterey Wealth or your Third Party Administrator if you have questions.
Adjustments to Compensation
Unless the Adoption Agreement states otherwise, there are certain items (e.g., pre-tax deferrals to 401(k) plan, reimbursed moving expenses, or the cost of group-term life insurance, etc.) that are excluded from compensation. Refer to your Adoption Agreement to see if any normally excludable items have been identified as being included.
What is compensation based on (determination period)?
In 2012, the maximum compensation that can be used to calculate employee and employer contributions in a retirement plan is $250,000. In your Adoption Agreement, compensation is calculated over an applicable period (also known as the determination period), and is defined by one of three options:
- Plan Year
- Fiscal Year
- Calendar Year
If you have a newly eligible employee is not eligible to join the plan as of the first date of the determination period, confirm whether your Adoption Agreement states whether the compensation earned prior to their entry date is included or excluded.
Issues/Mistakes
Since there are different definitions of compensation, the incorrect definition of what wages are subject to 401(k) contributions could have been communicated to payroll, resulting in certain types of pay being included.
The solution is for the Plan Administrator to be crystal clear on what is and isn’t included in compensation for your Plan. Whenever there is a “special” or “outside the normal” wage paid to your employees, confirm that whether the pay should be included before processing payroll.