One of the most challenging aspects of plan administration has to do with the proper treatment of participant compensation for contribution and nondiscrimination testing purposes. Plan sponsors must use compensation as defined in the plan document, and misapplication of compensation is one of the most common errors requiring correction in the administration of retirement plans.
Plans must define compensation using one of three definitions under Internal Revenue Code (IRC) Section 415: current includible compensation, W-2, or wages for income tax withholding purposes. Section 415 compensation must be used for calculating minimum required contributions, determining highly compensated individuals and key employees.
Plans may specify that some forms of compensation are excluded for allocation purposes. These include compensation paid before plan entry and elective deferrals. Plans can also exclude forms of compensation such as bonuses, commissions and overtime, subject to a separate nondiscrimination test to ensure that such exclusions do not favor the highly compensated. Compensation for plan purposes is limited to a statutory cap, which is $275,000 for 2018.
One of the more difficult compensation issues relates to amounts paid after separation from employment, known as post-severance compensation. Amounts may be includible based on how soon they are paid, and if they would have been paid regardless of the termination of employment. Pure severance payments are generally not includible in plan compensation.
When Plan Administrators are preforming nondiscrimination testing on plan contributions and benefits, the plan’s definition of compensation is not required to be used. Administrators must use compensation as defined under IRC Section 414(s), which can differ from the plan provisions. This allows more flexibility in proving an arrangement does not favor the highly paid than would be allowed under the plan definition.
It is vitally important that census data is accurate and details of employment and severance are properly communicated. The various definitions of compensation that apply to a plan are complicated and require a careful interpretation to ensure they are being applied properly to each part of the plan. Please contact us with any questions on this subject.
For questions or more information, please contact Richard Green at rgreen@windes.com or 844.4WINDES.
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