How is Compensation Defined?

Valuable Information on 401ks, Pensions, ESOPs, Form 5500 Preparation + More

Compensation in its simplest form is pay in exchange for services rendered, although gross pay includes additional forms of compensation aside from the hourly rate paid to employees. In reference to 401(k) plans, the term “pay” becomes more complex. Under the statutory safe harbor regulations an employer is required to include additional forms of compensation such as bonuses, overtime, commissions, tips, fringe benefits, etc. The purpose of which is to ensure that there are no discriminatory practices regarding 401k’s that benefit highly compensated employees.

Excluding the aforementioned forms of compensation does not meet the safe harbor regulations and may result in an employer(s) facing non-discrimination testing with the IRS. For example, if ABC Company allows a 10% contribution for all four employees but does not include overtime in that compensation for the non-highly compensated employees, ABC may have to undergo testing with the IRS. In another example, if all four employees were able to contribute the same percentage of income with all forms of compensation included, no testing will be required.

Common issues that employers have with safe harbor include the following: certain bonuses are excluded from contributions, the correct matching amount is not maintained for commissioned employees, deferrals aren’t consistent, and stock options aren’t calculated appropriately. If in fact an employer faces testing and fails, the contribution errors must be fixed through corrective distributions. Correction of such errors can be extremely costly depending on the gravity of the errors. Safe harbor plans can be extremely beneficial to employers, helping to avoid the IRS testing process and costly errors.

By Sarah McFarland