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A Better Partnership


Nov 2011
November 11, 2011

10 Common Plan Compensation Mistakes

Calculating compensation doesn’t seem like something that should trouble retirement plan administrators and sponsors. Yet, it is one of the most common errors made in administering retirement plans and doing it accurately requires significant attention to detail. Below is a list of ten common mistakes made when calculating plan compensation for defined contributions plans.
  1. Using Box 1 or Box 5 Wages. If your plan document says you use a W-2 or FICA definition of compensation, that does not mean you can automatically use a participant’s W-2 box 1 or box 5 wages for compensation. Usually these definitions require you to add or subtract additional items. For example, a participant’s 401(k) elective deferrals (other than Roth deferrals) generally must be added back to the participant’s W-2 box 1 wages to calculate plan compensation.
  2. Deferrals of Severance Pay. Pay related to an individual’s employment termination cannot be included in compensation for 401(k), 457(b) or 403(b) deferral purposes. The IRS has indicated severance pay is not pay to an employee and only employees may make tax-free deferrals. This also means an individual cannot elect to defer payments made after employment terminates, except that the individual may defer regular pay, vacation pay and sick leave pay if it is paid before the end of the year employment terminates or, if later, within 2 1/2 months of termination.
  3. Failure to Follow Plan Terms. Every retirement plan document must define compensation. It is necessary to know how your plan document defines it and follow that definition. You can be penalized for using a definition that is inconsistent with the terms of the plan document and you may end up giving employees incorrect contributions if you are using the wrong definition.
  4. Inconsistent Payroll Practices. If you have one plan document covering employees at multiple locations, each location should be calculating compensation the same way. Plan documents generally do not address how each specific item of pay should be handled, and some types of pay could arguably fall in more than one category (e.g., one location may classify a gift card as a fringe benefit and another as a bonus.)Compensation must be calculated uniformly with respect to all employees covered by a plan unless the plan document requires otherwise.
  5. Discriminatory Definition. A compensation definition will not be discriminatory if it falls within one of the safe harbor definitions based on W-2 pay, FICA pay or pay under Code Section 415. Any deviation from a safe harbor definition must not discriminate in favor of highly compensated employees and must be tested annually to ensure no discrimination is occurring. For example, a plan that excludes bonuses from compensation must test its definition annually because all of the safe harbor definitions require the inclusion of bonuses.
  6. Incorrect Period of Compensation. It is common to use the wrong time period for calculating compensation. Some situations require looking at plan year rather than calendar year compensation. Other situations require using only compensation for the period an individual is eligible to participate in the plan as opposed to the individual’s compensation for the whole year. For example, in determining compensation for a top heavy contribution, it is necessary to calculate compensation for the entire year.
  7. One Definition for Multiple Purposes. Plans require administrators to calculate compensation for multiple purposes, including deducting salary deferrals, figuring employer contributions, determining compensation or deferral limits, running non-discrimination tests and calculating top heavy contributions. The definitions for each purpose may differ, so it is important to know how many ways compensation must be calculated for a particular plan. Further, plans sometimes can be drafted to minimize the number of calculations required and simplify administration if there is flexibility on what should be included or excluded.
  8. Exclusion of Non-Cash Benefits. Sometimes a plan document’s definition of compensation will require inclusion of the value of non-cash benefits an employee receives. These amounts are often overlooked when calculating compensation to determine percentage salary deferrals and/or the amount of employer contributions for participants.
  9. Failure to Deduct Deferrals From Extra Payrolls. It is frequently forgotten that elective deferrals must be deducted from extra payrolls or special payments to employees where the pay falls within a plan’s compensation definition. For example, problems often arise when running extra payrolls to pay bonuses that should be included in compensation. Every time compensation is paid, regardless of the process, payroll processors should be trained to consider whether deferrals must be deducted from the compensation.
  10. Earned Income of Self-Employed Individuals. Special rules apply to the calculation of compensation for self-employed individuals. Compensation must be based on the individual’s earned income. Complicated formulas are then applied to adjust that income based on things like the individual’s FICA liability and any “employer” contributions the individual is eligible to receive. These issues tend to arise in plans sponsored by employers that are taxed partnerships.

If you suspect you are making a mistake in calculating compensation, you do not have to wait for your auditor, the IRS or a participant to discover it. We can review your compensation definition when your plan is amended or through a preventative audit. If we find an issue before someone else does, correction will be less painful and costly. Please contact Heidi Lyon or any other member of the Employee Benefits Practice Group for more information.

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