June 06, 2022

401(k) Plan Sponsors - It Doesn't Pay To Ignore Your Plan's Definition Of Compensation

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One of the most common errors in 401(k) plan administration continues to be a mismatch between a plan's definition of compensation and the actual compensation taken into account for plan purposes despite this problem being common enough for the IRS to include it in its "401(k) Plan Fix-It Guide".

In this All Things HR Blog, we will review scenarios in which this problem occurs and steps plan sponsors can take to minimize the risk of this happening to them.


Compensation in a 401(k) plan is used for a variety of purposes such as allocation of contributions, discrimination testing, 415 annual additions testing, and top-heavy testing. The Internal Revenue Code ("Code") permits a plan sponsor to select its own definition of compensation from among a list of safe harbors (e.g., W-2 wages) or a sponsor may adopt a customized definition of compensation that must be a nondiscriminatory definition under Code Section 401(a)(4). Compensation for purposes of allocations and nondiscrimination must satisfy Code Section 414(s) and may exclude certain common, typically non-cash forms of remuneration known as "safe harbor exclusions" (reimbursements or other expense allowances, fringe benefits (cash and non-cash), moving expenses, deferred compensation, and welfare benefits). Because both the Code and ERISA require a plan to be administered according to its terms, once a definition of compensation is adopted, the definition must be used for the purposes stated in the plan.

When a plan uses the wrong definition of compensation, it may make elective deferrals, matching, and non-elective contributions that are too high or too low, and its discrimination and other annual testing may be inaccurate. Plans in this situation may have to correct under the Employee Plans Compliance Resolution System, resulting in potentially costly make-up contributions and administrative costs.

So how does it go wrong?

Common Causes of Operational Failures Involving Compensation

The "Compensation Means Regular Pay" Misconception

Under the "Compensation Means Regular Pay" misconception, an employer selects a definition of compensation for its plan, for example, all amounts treated as wages for income tax withholding, but then in operation, only takes into account the regular base, hourly, and performance bonus compensation it typically pays its employees. Even though the employer also pays employees other types of taxable compensation (such as longevity or holiday bonuses, rewards for referring new employees, and cash for opting out of the employer's group health plan, etc.), it does not think about whether this non-regular pay is compensation for plan purposes, despite this compensation being wages for income tax withholding purposes.

The "Over and Under Inclusive Safe Harbor Exclusion" Error

As noted above, Code Section 414(s) allows an employer to exclude certain typically non-cash remuneration, provided the plan document provides for the exclusion. Unfortunately, some employers do not count as compensation some types of remuneration which would have been excludable under the safe harbor (e.g., imputed income on group term life insurance greater than $50,000), despite not having adopted the safe harbor. Another common error is employers that do adopt the safe harbor exclusion, either broadening the exclusion beyond what Section 414(s) reasonably allows (e.g., excluding all bonuses as "fringe benefits") or failing to exclude remuneration reasonably excluded under the safe harbor (e.g., taxable value of certain welfare benefits).

The "You Say Potato and I Say Potahto" Practice

With the "You Say Potato and I Say Potahto" practice, a plan sponsor will have multiple payroll feeds. For example, different feeds for different employer locations, or there will be multiple participating employers in the plan, each with its own payroll system. Under this practice, each employer determines for itself the payroll codes associated with the various forms of compensation it pays its employees, and independently determines if these forms of compensation are includable or excludable under the plan's definition. For example, one participating employer may decide that some forms of bonuses (e.g., referral awards, patent awards, suggestion bonuses, etc.) are compensation under the plan, but others determine they are not. In this scenario, different payroll systems for the same plan interpret a single definition of compensation differently - same words, different meanings.

The "Set It and Forget It" Problem

Under the "Set It and Forget It" scenario, an employer chooses an initial definition of compensation, properly categorizes each type of compensation it pays as plan compensation or not, and then does not revisit the categories when adding a new type of pay or changing the rules involving or treatment of the compensation paid.

Steps to Minimize Risk of Compensation Failures

There are a handful of important steps plan sponsors can take to minimize the risk of operational failures involving the definition of compensation.

  1. Learn The Plan - There is no substitute for a plan sponsor reading its plan's definition of compensation and understanding the nuances it includes and does not include. Plan sponsors should also understand the purposes for which the plan's definition(s) of compensation are used. Some portions of a definition will usually be easy to understand, but others, such as the meaning of "fringe benefits" as an exclusion from compensation, may require consultation with experienced legal counsel.
  2. Take Inventory - Employer payroll and the systems that run them can include dozens of categories of pay. A best practice is for a plan sponsor to review each payroll code and decide whether the pay associated with that code is or is not compensation for plan purposes, and adjust its system accordingly. When there is more than one payroll provider or separate payroll feeds, it is important that this inventory be taken for each one.
  3. Educate Your Team - As new personnel are given responsibility for payroll functions, providing them a basic understanding of the plan implications of various pay categories and the importance of properly applying the plan's definition of compensation is essential.
  4. Periodic Refresh - Employers adjust the forms of compensation they pay their employees from time to time. For example, an employer may add new incentive forms of compensation to attract and retain employees, particularly in the current competitive hiring environment. When any new element of pay is added or changed, plan sponsors should review how that new pay will be treated for compensation purposes under their plans. They can also use this as an opportunity to refresh a prior review of its payroll coding, especially if it has been many years since a payroll inventory (see #2 above) was last taken.

There are hundreds of moving parts in a typical 401(k) plan and many areas of where things can go wrong. Eliminating categorical compensation errors as one of these areas is an important best practice. Finally, a similar approach to understanding compensation for 403(b) and 457(b) plans, defined benefit pension plans and nonqualified deferred compensation plans is also important and can be undertaken using the same principles outlined in this blog.

ALM expressly disclaims any express or implied warranty regarding the OnPractice Content, including any implied warranty that the OnPractice Content is accurate, has been corrected or is otherwise free from errors.

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