Defining Compensation for 401(k) Plan Contributions and Testing
by Ethan Heck, QKA
How is “compensation” defined for 401(k) plan purposes?
The answer depends on which aspect of the plan is being examined. IRS Code and regulations provide a baseline definition, and in some cases, the plan document may specify other inclusions or exclusions. Plan administrators may need to work with a payroll expert or CPA to ensure that the definition of compensation is translated properly for retirement plan purposes.
How does the definition of compensation affect compliance testing and contributions?
The type of compensation used for each test can vary. Some tests allow the plan to define the compensation, while others have statutorily defined compensation. Let’s look more closely at the common plan requirements involving compensation.
Annual additions, highly compensated employees (HCEs), key employees, and top-heavy minimum contributions
Compensation for these purposes is defined under Internal Revenue Code Section (IRC Sec.) 415(c)(3) as wages, salaries, and other amounts includable in the participant’s gross income. Employers may use reported wages as a baseline. Compensation also must include retirement plan elective deferrals and other tax-deferred contributions, such as cafeteria plan contributions and qualified transportation fringe benefits. Employers may consider other compensation in the participant’s gross income including, but not limited to, medical benefits, moving expenses, and nonstatutory stock options. For self-employed sole-proprietors or partners, earned income would represent compensation. IRS Publication 560 provides more information on how compensation and deductions are determined for small business owners, including self-employed individuals.
Coverage, nondiscrimination, and ADP/ACP tests
While compensation for plan testing purposes is defined under IRC Sec. 414(s), employers may use the IRC Sec. 415(c)(3) definition because it is broadly inclusive and conforms to IRC Sec. 414(s) regulations. But certain types of compensation may be excluded as long as the definition remains both reasonable and nondiscriminatory. A reasonable definition is one that consistently excludes certain irregular or additional compensation, such as bonuses or commissions. A nondiscriminatory definition is demonstrated by either passing a compensation ratio test or meeting one of the following “safe harbor” definitions of excludable compensation:
Reimbursements and expense allowances, fringe benefits, moving expenses, deferred compensation, and welfare benefits.
Elective deferrals made to cafeteria plans, qualified transportation fringe benefits, 401(k) plans, 403(b) plans, 457(b) plans, SAR-SEP plans, and government pick-up plans.
Plan administrators should be familiar with any compensation exclusions in their plan document to know whether the plan meets a safe harbor or requires additional testing.
Compensation for contribution allocations
The compensation definition for safe harbor cash or deferred arrangement (CODA) contributions is limited to a reasonable and nondiscriminatory definition, as described above. However, other plan contributions, such as elective deferrals, matching, and profit sharing, can be made based on a compensation definition that discriminates in favor of HCEs. So while compensation can be discriminatory, the allocation itself cannot. For example, elective deferrals generally are still subject to ADP testing and matching contribution allocations are still subject to ACP testing. Profit sharing allocations are subject to general nondiscrimination testing.
What time period is used for the definition of compensation?
The period of time taken into account when defining compensation depends on the purpose of the definition. For most purposes, the plan year is the required time period. Other periods of compensation also may need to be tracked. For example, plan administrators can choose to limit the scope of compensation for contribution allocations and ADP/ACP testing to only what is paid after an employee becomes eligible to accrue or receive contributions. Sometimes called “post-entry compensation,” this may have a dual impact on the plan by either raising or lowering the ceiling on HCE contributions and lowering the amount of employer contributions overall by limiting each participant’s compensation for the year the participant becomes eligible.
Annual additions are measured in a plan’s limitation year. A “limitation year” can be any uniform 12-month period, but it usually coincides with the plan year. If it does not coincide with the plan year, a different compensation period, such as the employer’s taxable year, will be examined when measuring annual additions.
For key employees and HCEs, compensation is measured within specially defined periods. HCEs are measured during the “look-back year,” which is the 12-month period preceding the current plan year. The lookback year will always be a 12-month period. In contrast, key employees are defined by compensation earned in the “determination year,” which is the plan year containing the determination date for the top-heavy test. The determination date generally will be the last day of the preceding plan year, except for new plans, in which case the determination date is the last day of the first plan year. If the determination year would be a short plan year, the compensation threshold for key employees would be prorated accordingly.