401(k): Defining Compensation…Five Things to Watch

An employee’s compensation is an important component in the administration of a 401(k) plan. It is typically the basis for determining salary deferrals, matching contributions, additional employer contributions and non-discrimination testing. However, compensation can also be a source of frequent errors and confusion among the parties who administer the plan.

Here are five things to watch out for when you establish or update the definitions of compensation used in your 401(k) plan.

1. Compensation is often defined in the plan summary. If the plan is amended, update the plan summary, your payroll system, and any other documentation affected by the change as soon as possible to incorporate any changes made to the definition of compensation used by the 401(k) plan.  Also, remember to make updates at the beginning of each year to reflect any change made to the limit on the amount of compensation that can be considered under the plan ($260,000 in 2014 and $265,000 in 2015).
2. What’s included in compensation can become complicated with some life insurance, expense reimbursements, car allowances, bonuses, commissions and overtime pay. When defining compensation, consider and account for all types of employee income and payments, and meet with your payroll processor to confirm that all compensation types are being handled appropriately under the 401(k) plan.
3. Be aware that different definitions of compensation may be used in different circumstances. For example, the compensation amount used to calculate deferral amounts may not match the amount used for contribution testing.
4. Plan administration may be handled by a TPA or other third party. Make sure that these entities have accurate and up-to-date compensation definitions to perform their duties.
5. If you make a mistake, document it and take corrective actions as soon as possible. Often, corrections can be made by following the IRS Self-Correction Program. Even if the mistake is determined to be significant, if the error is corrected before the end of the second plan year after the mistake occurred, it can be self-corrected without paying a fee or making a filing with the IRS.

See 401(k): Find and Fix Compensation Mistakes for more useful information and guidance for employers who sponsor 401(k) plans.