Compensation: the money received by an employee from an employer as salary or wages. This is a fairly broad definition. However, when it comes to retirement plans, there are rules we must adhere to. There are consequences for not following those rules with respect to compensation. Compensation comes into play both in the contributions that go into the plan as well as the testing that must be run on your plan each year.
First and foremost, all retirement plans have a plan document that contains all of the rules and regulations that must be followed with respect to administering the retirement plan. One of those items included will most definitely be the definition of compensation. The first step will always be to consult your plan document to see what compensation you should be including. Compensation may simply be W-2 wages. Compensation may be included for the entire plan year, or perhaps just for the period of the year when the participant was eligible for the plan. Compensation may include or exclude bonuses, commissions, or overtime wages. Use those parameters to set up your payroll system. Your payroll system will calculate each participant’s deferral from their paycheck using that definition. If you make an ongoing match or nonelective contribution, that payroll system should also calculate those employer contributions you are gifting to your employees using those definitions.
Definitions of compensation may or may not be the same for different contribution types. For example, employees may be able to defer all of their pay – salary, hourly wages, overtime, and bonuses. But, when it comes to the match, you may be able to elect to exclude some of those types of compensation from their matching calculation. There are also certain items that may be included on their W-2 as taxable wages such as life insurance premiums that may be included for the calculation of their employer contributions, but the participant cannot actually defer those amounts from pay. So, the deferrals would be calculated on the wages less those amounts, while the match would be calculated on the full taxable wages. If you do elect to exclude certain types of compensation, it may subject your plan to additional testing because the compensation exclusions must not be discriminatory.
The IRS also caps considered compensation for retirement plan purposes. Each fall, they set the limits for the upcoming year. For 2021, the compensation is capped at $290,000. If an employee makes more than that, for all plan purposes, their compensation will be shown as $290,000. This is the maximum amount that will be used for all calculations and all testing that is run on the plan. Many payroll systems will update that amount annually, however, you should check each January to make sure the proper compensation is being used.
Each year, there are certain tests that must be run on retirement plans that may require statutory compensation to be used. Statutory compensation would be all wages, salaries, and fees. It would include deferrals to the retirement plan from the employee’s paycheck as well as to other tax savings plans such as 125 plans. While statutory compensation is capped as stated above, it must always be for the full plan year. This compensation would be used to determine who will be a Key employee or a Highly Compensated employee. If your plan is considered Top-Heavy, this is the compensation that must be used to determine if you have met your Top-Heavy requirements. Lastly, this compensation is used in determining the maximum deductible contribution for each year. Other tests such as ADP or ACP testing and 401(a)(4) testing may be allowed to use variations of compensation if the plan document allows for such variations. Plan documents may also be designed to allow any alternative definition for these tests giving you the maximum flexibility.
Lastly, compensation must be for earned income for employees, including self-employed individuals. If someone has no earned income for the year, they are not considered benefitting nor are they included in any testing for that year. If an owner or partner has self-employment income reported on Schedule K-1 of the Form 1065 or on a Schedule C, that income is included. In those cases, the compensation used would be the net earnings from self-employment. Those persons are included as employees of the company and included in all calculations and all testing for the plan. Self-employment earnings can be tricky, and a tax professional may need to be involved with those calculations.
What happens if you used the wrong definition of compensation? Well, that depends! If you included or excluded something improperly from an allocation or from one of the tests, corrections should be made to the plan as soon as they are discovered. If you are in violation of the plan document or an IRS requirement, there could be penalties involved to put your plan in right standing again. If the violation is small in scale and caught quickly, it may be possible to self-correct under the IRS Employee Plans Compliance Resolution System (EPCRS). However, if the failure to follow the rules is larger in scale, you may have to file under the Voluntary Correction Program under EPCRS. That will involve a filing fee to receive a formal approval of your correction. Lastly, if your failure is discovered by an IRS auditor in the event you are audited, EPCRS has the Audit Closing Agreement Program (Audit CAP) which requires the correction plus a sanction to correct the issue.
ML&R Wealth Management serves as an investment advisor and third-party administrator for our retirement plans. We will work with you on setting up the compensation definitions in your plan document and ensuring your plan is using the proper definition of compensation in your testing and allocations each year. If you find yourself in need of a correction program, we can help you navigate that as well.