The definition of compensation in a retirement plan is a pivotal element that affects how deferrals, matching contributions, profit sharing contributions, and plan limits are determined. An error in compensation, even a small one, can result in substantial correction costs that expand dramatically over time. For more on this failure and the required corrections, see our blog post Correction War Stories (Part 1): Oops, Was That Plan Compensation?.
It is critical to make sure that the compensation amounts used in calculating plan contributions and plan limits are accurate at all times. What is the best practice to ensure this? Ideally, the employer would:
- Review and clearly understand the plan’s definition of compensation.
- Verify that payroll coding is initially set up to match the plan’s definition of compensation.
- Set a procedure in place that anytime a change is made to payroll coding, generally when a new type of compensation is added, it is verified against the plan definition.
- At least annually, conduct an internal review of the types of compensation that are paid by the employer, how they are coded in the payroll system for plan purposes, and whether they are coded properly to reflect what is included in income for plan purposes.
- Correct any mistakes as soon as practicable to mitigate the costs of the failure.
Step 1: The Plan’s Definition of Compensation
A plan’s definition of compensation generally starts with a base definition like “all income reported on Form W-2” (“W-2 Income”) Using that example, do you know what income is reported on Form W-2? Salary, certainly. Bonuses? Tips? Fringe Benefits? Post-Severance Compensation? Severance? Hint: One of those is not W-2 income, the rest are.
From there, the plan may exclude certain types of income that would otherwise be included in the base definition. For example, an employer may want to exclude bonuses because their employees would be unhappy with a reduced bonus, or non-cash compensation, which can be difficult from which to defer. And another decision is whether to exclude compensation earned during the plan year prior to the employee entering the plan. Obviously that compensation is W-2 Income, but does the employer want to include it, say when calculating a limit on matching contributions? Or in determining the employee’s pro rata share of a profit sharing contribution?
So you see, there is no “one size fits all” definition of compensation, each employer may have special adjustments that it wants to make to even the most basic of definitions.
Step 2: Setting Up Payroll Coding
All of the compensation recordkeeping is run through an employer’s payroll system: what compensation is earned and when, what type it is, what types of taxes apply, what benefits are affected, etc. An experienced payroll administrator, in conjunction with a reasonably sophisticated payroll system, will know how to set up a payroll to account for various types of income and how they must be taxed and reported. However, they may not be aware of customized provisions for plan compensation purposes, so it is imperative that the employer make sure that someone is looking at this issue when the plan administration is set in place.
Step 3: Tracking Changes in Compensation
Every time a new item of compensation is created, it must be assessed for its inclusion or exclusion from income for plan purposes. Let’s assume the following for illustration:
- A plan has a basic definition of W-2 Income
- The plan document does not exclude bonuses, but does exclude fringe benefits.
- The payroll system is set up correctly when the plan was originally effective.
- About 3 years later, the employer decides to give “service awards” to incentivize employee retention.
- The next year, the employer wants to compensate employees who have to move into the area to perform their job duties, and begins giving “moving bonuses” to eligible employees.
Will the payroll department know that a “service award” is a bonus and code that category to be included in plan compensation? Will they know whether a moving bonus is a bonus or a fringe benefit? Maybe. But if there is no procedure in place that requires them to verify how this new type of compensation is to be treated for plan purposes, it may just get lost in the shuffle and be coded properly for tax withholding but not for plan purposes.
Step 4: Annual Compensation Reviews
It is a good idea to include in the plan’s procedures that the payroll records for the year will be reviewed internally at least once each year. Even if your plan is a large plan that is reviewed by an outside auditor each year for Form 5500 purposes, employers can’t depend on the auditor to catch this. It is the employer’s responsibility as the plan administrator to ensure that the plan is being operated in compliance with plan terms, and that participants are receiving the correct contributions under the plan. This will likely entail a collaboration between benefits and payroll personnel, possibly in conjunction with assistance from the third-party administrator and even benefits counsel, especially if errors are found.
Step 5: Correct ASAP
Correcting any qualification failures swiftly is important, but it is particularly crucial in the case where there is mistake in plan compensation calculations. Even a small error can have significant ramifications if left unchecked.