Our company pays a number of different types of bonuses—signing bonuses, spot bonuses, holiday bonuses, production bonuses, etc. You get the idea. We know that bonuses paid once the employee has worked for us for a while count for purposes of the retirement plan, but we would like to carve out signing bonuses.
Is it possible to disregard signing bonuses from plan compensation or do we have to treat those the same as all other bonuses? If they must all be treated the same, could we carve out all bonus payments?
The answers to your questions are “yes” and “yes.” But, if you regularly follow Questions of the Week, you know there is no such thing as an answer that is that short.
The more detailed answer comes down to a couple of factors—what the plan document says and whether the exclusion would cause the plan to be discriminatory.
Know Your Plan Document
The most common definitions of compensation used in plan documents are tied to amounts reportable on Form W-2 or used to determine income tax withholding. There are some nuances between the two, but both count bonuses (as well as other “irregular” pay like commission and overtime).
Since a signing bonus is compensation paid in exchange for the employee working for you, it's treated the same as any other type of bonus unless your plan document calls for different treatment. Your plan document should also indicate whether the exclusion is meant to apply across the board or just for certain purposes. In other words, you could completely disregard bonuses or you could allow employees to make 401(k) deferrals from their bonuses but ignore those amounts when calculating the company profit sharing contribution.
A word of caution—be sure the wording in your document is specific and clearly articulates your intent. For example, some documents allow you to simply check a box to exclude bonuses; however, checking that box would kick out all bonuses, not just signing bonuses. If that is what you want to do, great. But if you are just targeting signing bonuses, make sure the document language is worded as such.
Although it is possible to modify a default definition of compensation, there is a special test in place to ensure the alternate definition does not discriminate in favor of the plan’s highly compensated employees. This might happen if the definition reduces non-HCE plan compensation significantly more than it reduces HCE plan compensation.
The so-called compensation ratio test does exactly what its name suggests. The compensation ratio is simply the included compensation divided by total compensation. The test takes that amount for each plan participant and compares the average for the HCE group to that of the NHCE group to ensure the spread is within an acceptable range.
The trick is that there is no clear-cut definition of what is acceptable. In audits, the IRS has generally concluded that a spread of three (3) percentage points or less is OK, while anything exceeding that limit is discriminatory.
When considering whether or not certain forms of compensation should be included or excluded, it is critical to work with someone who is knowledgeable about the nuances of compensation definitions. Some items can be excluded without triggering the compensation ratio test, while other exclusions mandate testing. Another factor is that differing treatment of different types of compensation means that your payroll system must be capable of tracking it all to ensure proper treatment.
As with so many of these retirement plan rules, the key is to plan ahead. If you are considering changes to your plan or you anticipate upcoming business changes, give us a call to discuss the potential impacts and prepare any projections that might make sense. We are also glad to work with you and your payroll provider to ensure as smooth an implementation as possible.
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