Can A Departing Employee Make 401(k) Contributions From Severance Pay?

DWC | 07/10/18

QOTW - 7.10.2018 - Can a Departing Employee Make 401k Contributions From Severance Pay - Retirement Plan Design

Facts

When certain employees terminate employment with our company, we agree to continue severance payments for a period of time after they leave.  Some of these employees have asked us to continue withholding 401(k) contributions from their severance pay.

Question

Can a former employee continue to defer into our plan out of his or her severance pay?  Are we required to include severance pay when calculating any company-provided contributions?

Answer

Unlike most of our questions of the week, these two have really short answers.  They are “no” and “no.”  But, it wouldn’t make for a very interesting read if that was the end of the story.

To more fully answer this question, we have to distinguish between severance pay and post-severance pay.  We know, it sounds like splitting hairs at its worst, but the difference is actually pretty important.  Post-severance pay is any compensation that is paid to an individual after he or she terminates employment.  Severance pay is a subset of post-severance pay and is essentially an amount paid to someone to get them to leave.

Severance vs. Post-Severance Pay

To get to the heart of the question, we have to identify the types of post-severance compensation that an employee would receive even if he or she remained employed vs. those that are only payable if/when the employee terminates employment.

Here are some examples of amounts an employee might receive either way:

  • Unused vacation or sick leave,
  • bonuses or commissions earned but not yet paid, and
  • scheduled payments from certain non-qualified deferred compensation plans.

The reason this is so important is that these amounts are counted as compensation for retirement plan purposes.  That means employees can defer from them, and companies must generally count them when determining employer matching and profit sharing contributions.

Severance pay, on the other hand, is only payable if the employee terminates employment.  It is not a payment for services rendered.  As a result, employees are never allowed to defer from true severance pay, and companies should not count it when determining matching and/or profit sharing contributions.

For more information on plan compensation, please visit our Knowledge Center here, here and here.

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Topics: Question of the Week, DWC, Compensation, Severance Pay, Post-Severance Pay, Retirement Plan Design

The views expressed in this blog are those of the authors and do not necessarily represent the views of any other person or organization. All content is provided for informational purposes only and is not intended to be tax or legal advice.