Our company has a safe harbor 401(k) plan. In addition to employees making deferrals, we make a company contribution equal to 3% of each person’s compensation. We deposit both types of contributions each pay period, so in theory at least, we should be all set by the end of each year. However, it seems that each year, our TPA comes back to us with adjustments that need to made. They tell us that it has something to do with how we determine compensation.
How do we correctly determine which compensation to use to calculate our safe harbor contribution so that we avoid these year-end adjustments?
Similar to other provisions that govern your plan’s operation, the definition of compensation you must use is written into your plan document. It is easy to brush off a review of something like this because it seems so obvious. Compensation is simply the amount employees get paid, right? There are some nuances, however, that require a closer look.
Here are several compensation-related items that we often cause confusion.
Newly Eligible Participants
Plans are typically written to allow employees to join the plan at several points throughout the year, after satisfying any age and/or service requirements. These so-called entry dates could be semi-annual or daily or anything in between. For the sake of this example, let’s assume entry dates are on the first day of each quarter.
If a new participant first joins the plan on October 1st (the first day of the 4th quarter), should his or her 3% company contribution be based on compensation for the entire year (starting January 1st) or just from October 1st forward? For some, common sense dictates that it would be based on pay starting October 1st. However, other employers prefer to place everyone on even footing by using full year pay even if some enter the plan later in the year. If your plan document requires using full-year pay but you only make contributions for a person starting with the date he or she first becomes eligible, then year-end adjustments are necessary.
The IRS places a limit on the amount of compensation that can be considered for any single participant in a given year. For 2018 that limit is $275,000, and it is indexed for inflation (using the Consumer Price Index) in $5,000 increments. For companies that calculate and deposit contributions each pay period, it is not uncommon to forget to stop contributions for higher paid folks once they hit this compensation cap. If that happens, the company contributions based on pay over that limit must be removed from the affected participants’ accounts.
The most commonly used definition of compensation we see is box 1 of Form W-2, with any pre-tax withholdings (401(k) deferrals, health insurance premiums, etc.) added back. Most of the time, that essentially means an employee’s gross pay for the year. But what about irregular forms of pay such as bonuses, overtime or commission? Some companies prefer to limit plan contributions to only “base” pay because it is easier to budget. However, if the plan document says to use gross compensation, then all these irregular amounts must be factored in to the calculation. It is possible to exclude some or all of these types of pay, but doing so triggers additional nondiscrimination testing requirements to make sure the definition isn’t being manipulated to the benefit of the plan’s highly compensated employees.
There are generally two ways a company can cover expenses for an employee – through a reimbursement or an allowance. This is actually a fairly detailed area unto itself, but at a high level, a reimbursement occurs when an employee presents documentation of the actual expense incurred and the company reimburses that amount. An allowance is where the company automatically pays the employee a certain amount to defray expenses but does not require documentation or adjust the amount based on the actual expense incurred. Reimbursements are generally not taxable, not reported on Form W2, and are not counted as compensation for purposes of retirement plan contributions. Allowances, on the other hand, are reported on Form W2 as taxable income and must be include when calculating the company contribution to the 401(k) plan.
There are many different types of compensation, and the retirement plan rules afford a good bit of flexibility to either include or exclude these types. The trick is to make sure your plan document accurately reflects the way you want to operate in practice. One of the best ways to ensure that is to discuss the types of compensation you pay and which ones you wish to include or exclude with your TPA. They can advise on any additional testing requirements or compliance implications and make sure the plan document reflects your intent.
And don’t forget your payroll provider. We have seen many situations in which the plan document was properly updated, but no one told the payroll provider to make any changes on their end, resulting in contributions continuing to be calculated each pay period using an old definition of pay.
For more information on plan compensation, please visit our Knowledge Center here.