Employee Benefit Plans: The 411

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

What is Compensation?

Compensation is key for 401(k)’s and other employee benefit plans. In many plans employees make contributions based on a percentage of their compensation. Other times, employer matching or profit sharing uses compensation as the basis for allocating employer contributions to employees.

Compensation is generally defined as gross wages, which are subject to income tax withholding. This includes all W-2 wages such as sales commissions, tips, bonuses, and fringe benefits. Often cash bonuses and manual checks are overlooked for these calculations. Failure to properly calculate compensation could result in improper deferral percentages or improper allocations of employer contributions; which ultimately may lead to revocation of the plan’s tax exempt status if not corrected. There are exceptions to the rule, and each plan may define compensation differently, so be sure to refer to your plan document for the exact definition.

Most plan sponsors have the ability to modify what is included in the definition of compensation through options in generic prototype plan adoption agreements or through plan amendments. Further, employees may request to modify their deferrals as it relates to their specific compensation (i.e. no deferrals from a year-end bonus or no calculation of deferral on the reported tip amounts). Such modifications should be documented by the employer and maintained in the employee’s  personnel file with other benefits information.

If you discover that you have improperly calculated compensation for employee deferrals or employer contributions, you should contact your ERISA attorney and consider the Voluntary Fiduciary Correction Program. You will likely have to make additional contributions to the plan to make those employees whole for the contributions they did not receive based on the error.

Jill Smith