Compensation Jeopardy: Things You Might Not Know About Your Retirement Plan
According to the IRS, using incorrect compensation amounts to calculate retirement plan benefits and conduct annual compliance testing is one of the most common errors they see. How can such a seemingly straight-forward topic be that confusing? Find out in this episode of Compensation Jeopardy! Be sure to phrase your responses in the form of a question!
Our first category is...
Compensation Paid to Business Owners
And the answer is: Sole proprietors, partners, and certain LLC members have THIS in common.
Response: What is earned income?
*ding, ding, ding*
You are correct!
If you are self-employed, special rules apply when calculating your retirement plan compensation, and it is a circular calculation involving enough variables to make anyone’s head spin. For starters, earned income is reduced by half of the self-employment taxes you owe for the year. This involves a separate set of calculations to derive the amount of the deduction. If you also have W-2 compensation from the business (an unusual occurrence but does happen sometimes) and had some employment taxes already deducted, it can also impact the calculation.
The calculation is further complicated if you have other employees. For example, if you are a sole proprietor with employees who are covered by your retirement plan, you must deduct any matching and/or profit sharing contributions you make for them as a business expense, which reduces your earned income. If you are a partnership with another partner, then each of you must reduce your earned income by a share of the total company contributions for employees in the same proportion as each of your ownership/partnership interests. The more owners/partners involved, the trickier the calculation becomes.
The next step is to calculate your company contribution, which is based on your compensation as described above. But that amount is also a business expense which further reduces the compensation used to calculate your contribution. Yes, a circular calculation, indeed.
And just because your total earned income is well above the annual compensation limit ($275,000 for 2018 and indexed for inflation) doesn’t mean you can skip all the fun. It is still important to go through the process to ensure that the reductions described above do not reduce your net earned income below the limit.
If your head isn’t spinning, you are doing better than most! The good news is that DWC can work with you and your accountant to ensure all of the necessary factors are considered and take care of these calculations for you.
And the Double Jeopardy answer is: This type of payment to a business owner is not considered earned income for retirement plan purposes.
Response: What is a subchapter S corporation dividend?
Although reported on a Schedule K-1 that is very similar to partnership income, S corporation profits that are passed through to the owners at the end of the year are not counted as compensation when it comes to the retirement plan. So, if an S corp owner receives $100,000 in W-2 compensation and $150,000 in distributed profits, the plan only considers $100,000 and not the full $250,000. For that reason (among others), it is important for S corp owners to review their own compensation strategy to make sure they don’t inadvertently reduce or increase their own contribution.
Our second category is....
Amounts Paid After an Employee Terminates
And the answer is: This type of compensation is NEVER counted as eligible plan compensation.
Response: What is severance pay?
Right you are!
But contestant beware, “severance pay” is not the same as “post-severance pay.” Confused? We would be surprised if you weren’t! Post severance compensation includes any amount that is paid to an employee after he or she has terminated employment and includes items such as:
- Payment for unused vacation or sick leave;
- Payment of earned but not yet paid bonuses or commissions;
- Distributions from certain non-qualified deferred compensation plans; and
- Traditional severance when someone is essentially paid to leave.
The first three are amounts that the employee would have been entitled to receive even if s/he remained employed. If paid to the employee by the later of two-and-a-half months following termination or the end of the plan year of termination, the default provision is to count these amounts as plan compensation; however, the plan document can be amended to modify this definition.
The last bullet point—traditional severance—is only paid if an employee leaves and can never be counted as plan compensation. That makes it especially important not to promise a departing employee that he or she can make deferrals or receive company contributions based on such amounts.
Now for category three....
Non-Recurring or Irregular Compensation
And the answer is: "These types of non-recurring compensation are always counted as plan compensation unless specifically excluded by definition in your plan document.”
Response: What are bonuses, over-time and commissions?
You are on a roll—CORRECT!
The most common definitions of compensation in plan documents are tied to amounts reported on Form W-2 or amounts used to determine income tax withholding. Although there can be some nuances that separate these two definitions, both include bonuses, commissions, and overtime.
While important parts of an overall compensation strategy, all can wreak havoc on the operation of a 401(k) plan. In most instances, employee deferral elections should be applied to these amounts just like any other payroll. If included with regular paychecks, it doesn’t create much, if any, additional effort; however, if paid in a separate check outside of payroll, it can be easy to overlook them. In addition to withholding 401(k) deferrals, these forms of compensation must also be considered when calculating matching and profit sharing contributions, and performing compliance testing.
There are some exceptions, but they must be spelled out in the plan document. In other words, the plan must be written in a manner that specifically excludes these compensation “extras” if that is your intent.
Contestant beware! The exclusion of these types of irregular compensation requires special nondiscrimination testing each year. If you exclude a greater percentage of compensation from your lower paid employees than your higher paid employees, you may not be able to exclude that compensation after all, and you may have to make some additional corrective contributions to the plan.
Our final Compensation Jeopardy category of the day is....
Allowances and Non-Cash Compensation
The final jeopardy answer is: Personal use of a company car, relocation allowances and gift cards are examples of this type of compensation.
Response: What are taxable fringe benefits?
That is correct! We have a winner!
Fringe benefits come in two varieties, taxable and non-taxable. The taxable ones are part of plan compensation, while the non-taxable ones are not. The difference usually depends on whether the employee must provide substantiation of expenses in order to receive the payment. For example, if a company agrees to reimburse an employee for costs associated with relocation for the job and the employee must provide receipts to document actual expenses, the payment is considered a reimbursement, is not taxable, and is not reported on Form W-2. However, if the company simply pays the employee, say $5,000, to cover moving expenses regardless of the expenses actually incurred, it is treated as a taxable allowance and is reported on the W-2. It is similar with automobile related expenses…a direct mileage reimbursement is a non-taxable fringe benefit, while a monthly auto allowance is taxable.
What if the benefit does not involve cash? Items like gift cards or allowing an employee to use a company-owned car for personal use have monetary value and are subject to income tax (and therefore count as plan compensation) even though there was no actual cash involved.
If there was no payment, how can deferrals be made? This can be tricky and depends on how your plan document is written. If you pay non-cash compensation, the plan can be designed to exclude these amounts completely or just with regard to employee deferral elections. The good news is that if the plan is written to exclude all taxable fringe benefits, no additional testing is required each year.
If you aren’t sure what your plan requires or you pay different types of non-traditional compensation, give us a call. We once had a client who paid “fish tank pay.” No matter what you call it, we can help you know and understand your plan’s definition of compensation so that you keep the plan out of jeopardy.